Alpha and Beta

Risk, return and volatility are all interlinked. Before you invest, you need to get a better idea of these metrics, so you can chart out your investment plan accordingly. But wouldn’t it be hard to do this for each asset or investment option you are interested in? Of course, it would. That’s why there are certain measures or tools that can help you gauge how a specific asset performs in comparison with a benchmark.

That way, you can easily determine if an investment option is generally better or worse than the average asset in that category. For example, take the case of the stock market. Suppose you are interested in around 3 to 4 stocks. They belong to good companies, and those companies seem to be doing well. But as a beginner, you don’t know anything more than the general perception around those stocks. Now, wouldn’t it be better if you had some concrete tools that told you how good those stocks are, in comparison with the overall market?

Two such tools or metrics are alpha and beta. And in this chapter, we’re going to be breaking them down and looking at the alpha and beta meaning.

Alpha: An introduction

One of the first things you will want to know before you invest in an asset is the kind of returns that asset delivers, isn’t it? Alpha is a metric that helps you determine this. It can be used in the context of any investment. But more often than not, investors make use of alpha in the context of stocks.

So, what is alpha anyway? Simply put, alpha is a measure of the returns from a particular investment, in comparison with a benchmark. For example, in the case of the stock market, the alpha of a stock shows you how that stock has performed when compared with a benchmark, like the Nifty.

Alpha can also be measured for a portfolio of assets, just like how risk can be calculated for an individual asset as well as a portfolio of assets. The returns from an investment (or a portfolio) can be higher or lower than the average performance of the market, which is the benchmark. And the difference between the benchmark performance and the asset’s performance is the alpha.

A closer look at Alpha

Alpha is represented by the Greek letter α. And as we saw above, it is the difference between an asset’s (or a portfolio’s) performance, and the benchmark returns. So, naturally, the alpha can be positive or negative. Here are two scenarios to explain this further.

• Scenario 1:
  A stock generates returns of 10% during a given financial year. Over the same period, the benchmark index gives returns of 6%.
  So, in this case, the alpha of the stock will be 4% (10% - 6%).
• Scenario 2:
  A stock generates returns of 12% during a given financial year. Over the same period, the benchmark index gives returns of 15%.
  So, in this case, the alpha of the stock will be -3% (12% - 15%).

As you can see, alpha can be positive or negative. A positive alpha means that the asset or portfolio has performed better than the benchmark, while a negative alpha means that the asset has performed worse than the benchmark. The alpha can also be zero. This basically means that the returns from the asset match the benchmark. Investors can make use of this information to gauge the nature of returns that an asset or a portfolio is likely to generate.

While the alpha is generally represented as a percentage, it is also sometimes represented as whole numbers. So, in scenario 1 above, the alpha as a whole number would be 4. And in scenario 2, it would be -3.

Beta: An introduction

Beta is also often referred to as the beta coefficient. It indicates the volatility of a stock or an asset in comparison with the market benchmark. This tool or metric gives you a good idea of how much the price of an asset fluctuates, when compared with the market’s volatility as a whole.

This helps you as an investor, because it gives you a good idea of how volatile a particular stock or asset is. Recall from the previous chapter how volatility can give you an idea of the potential risk and return from an asset? When you benchmark the volatility of an asset against the market, you can identify if the asset is more volatile than average. Then, you can make your investment decisions accordingly.

A closer look at Beta

Represented by the Greek letter β, the beta of a stock or an asset has a baseline value of 1.0. A beta of 1 indicates that the asset is very strongly correlated with the market. This essentially represents the systematic risk component. 

• Beta values less than 1.0

If a stock has a beta that is less than 1, it means that the stock is less volatile than the market, on average. In other words, it is less risky than the market, and by adding such a stock or asset to your portfolio, you bring down its overall risk.

• Beta values greater than 1.0

If a stock has a beta that is greater than 1, it means that the stock is more volatile than the market, on average. In other words, it is riskier than the market, and by adding such a stock or asset to your portfolio, you increase its overall risk.

Wrapping up

So, this sums up the basics of alpha and beta. These two concepts play an important role in the Capital Asset Pricing Model. But before we get there, there are two other important concepts we need to discuss, namely the risk-free rate and the equity risk premium. Head to the next chapter to learn more about this.

A quick recap

• Alpha is a measure of the returns from a particular investment, in comparison with a benchmark. 
• Alpha can also be measured for a portfolio of assets, just like how risk can be calculated for an individual asset as well as a portfolio of assets. 
• Alpha is represented by the Greek letter α.
• It can be positive or negative. 
• Beta is also often referred to as the beta coefficient. 
• It indicates the volatility of a stock or an asset in comparison with the market benchmark. 
• Represented by the Greek letter β, the beta of a stock or an asset has a baseline value of 1.0. 
• A beta of 1 indicates that the asset is very strongly correlated with the market. 
• If a stock has a beta that is less than 1, it means that the stock is less volatile than the market, on average. 
• If a stock has a beta that is greater than 1, it means that the stock is more volatile than the market, on average.