Alpha vs Beta: What these terms really mean for mutual fund, stock investors
If you are confused by personal finance terms, jargon and calculations, here’s a series to simplify and deconstruct these for you. In the 85th part of this series, Riju Mehta explains how these indicators differ from each other.
The higher the beta, the higher the volatility or risk associated with an asset.
Alpha and beta are core personal finance indicators that help investors understand investment returns and market risk by comparing a stock or mutual fund’s performance against a benchmark.
What’s alpha?
Alpha measures the performance of a stock, mutual fund or an investment with respect to a benchmark. In other words, it reflects an investment’s outperformance or underperformance compared to its expected return, which depends on its level of risk (denoted by beta).
Alpha can be either positive or negative, and is expressed as a numerical value, which can represent a percentage. For instance, a positive alpha of 2 implies outperformance, indicating that the investment return was 2% more than that of the benchmark, while a negative alpha of 2 shows underperformance, indicating that the return was less than that of the benchmark. If alpha is positive for an investment, it’s considered to be a good one.
The base value of alpha is taken as zero, which means the returns are in line with the predicted returns. A value above zero indicates outperformance, while that below zero indicates underperformance. Alpha is often used along with various risk ratios, such as beta, Sharpe ratio, standard deviation, etc., to gauge the complete risk-return profile of the investment.
How do these differ?
What’s beta?
Beta coefficient or beta measures the volatility or risk associated with a stock or an investment compared to the broader market. It helps the investor gauge whether the risk of investing in a particular stock or any other asset is higher or lower than the benchmark. Like alpha, it’s also expressed as a numerical figure. The higher the beta, the higher the volatility or risk associated with an asset.
The base line value for beta is considered 1, where the volatility associated with the asset is aligned with the broader market. If it is less than 1, it’s volatility is lesser than the market, and if it is more than 1, the risk or volatility is higher than the market.
A zero beta value means the asset is uncorrelated with the market. A positive beta indicates the asset is moving in the same direction as the market, and a negative value implies it’s moving in the opposite direction.
