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All investors want the best possible returns on their capital, but risk tolerances vary greatly. That means each investor must find the right balance between risk and reward to earn an acceptable return while still sleeping at night. Alpha and beta are metrics that can help investors decide whether (or not) to buy an investment based on its risk and return profile.
Alpha measures an investment's return (aka performance) relative to a benchmark, while beta measures an investment's volatility compared to the overall market. Together, these statistical measurements help investors evaluate the performance of a stock, fund, or investment portfolio. Here's a closer look at alpha and beta—and how you can use these metrics to make investment decisions.
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What is alpha?
Alpha (α) measures an investment's return relative to its expected return. It's usually a single number, such as +2 or –1, representing the percentage an investment returned above or below a related benchmark index, such as the Standard & Poor’s (S&P) 500 or Russell 2000.
RELATED: Dow vs Nasdaq vs S&P: What's The Difference?
A positive alpha means the investment outperformed the benchmark index, while a negative alpha shows it underperformed. For example, an investment with a +2 alpha exceeded the benchmark index's performance by 2%, while a –1 alpha indicates the investment underperformed by 1%. When the alpha is 0, the investment's returns matched the benchmark's.
How is alpha calculated?
To calculate alpha, subtract the benchmark return from the asset's return.
Alpha = asset return-benchmark return
For instance, if a stock has a 14% return and the S&P 500 returned 10%, the alpha would be 4%. If the stock returned 8%, the alpha would be –2.
Alpha example
Alpha is often used to gauge an active portfolio manager's performance. A higher alpha means the fund is outperforming the market. While fund managers can generate alpha over various time horizons, it's most meaningful when alpha is produced consistently over the long term.
Legendary investor Warren Buffett's company, Berkshire Hathaway, is frequently used to illustrate alpha. According to the 2022 Berkshire Hathaway annual report, Berkshire had a compounded annual gain of 19.8% between 1965 and 2022 versus 9.9% for the S&P 500. (Note that Berkshire Hathaway is a corporation that operates similarly to a fund in that it invests in stocks and other securities.) It outperformed the market 39 out of 58 years.
A $1,000 investment in the S&P 500 in 1965 would have been worth about $239,000 by the end of 2022. Meanwhile, the same investment in Berkshire would have grown to more than $35 million, thanks to the power of compounding. So, even though Berkshire didn't beat the market every year, it produced a high alpha over a long period, which is more meaningful than a short-lived positive alpha.
Pros and cons of alpha
Pros
- Shows how an investment performed relative to a benchmark index.
- Helps you evaluate whether an active fund manager adds value to your investment.
Cons
- Measures past performance and can't guarantee future results.
- Can give misleading results if an unrelated benchmark is used.
What is beta?
While alpha is a measure of excess return, it doesn't show the expected return for a particular risk level. That's where beta comes in.
Beta (β) compares an investment's historical volatility to the market's average volatility. The SPDR S&P 500 ETF Trust (SPY), an exchange-traded fund (ETF) that tracks the S&P 500, is commonly used as the benchmark. The market always has a beta of 1. Here's a rundown of what the various beta values suggest:
- Beta >1: Higher volatility (i.e., riskier) than the index with higher potential returns.
- Beta =1: Exactly as volatile as the market.
- Beta <1: Lower volatility (i.e., lower risk) than the index with lower potential returns.
- Beta <0: Negatively correlated to the market.
Ultimately, the higher the beta, the higher the volatility, risk, and potential rewards—and vice versa.
How is beta calculated?
To calculate beta, divide the covariance of an investment's return and the market's return by the variance in the market's return.
Beta = [Covariance (Ri, Rm)] / Variance (Rm)
Where:
Ri = investment return
Rm = market (benchmark index) return
The good news is that you don't have to calculate beta values by hand. Microsoft Excel and Google Sheets have built-in covariance formulas that make calculating beta easy. Better yet, you can research an investment's beta online: Many financial websites publish beta along with other metrics, such as price-to-earnings ratio (P/E) ratio, earnings per share (EPS), and return on equity (ROE).
Beta example
Say you're considering investing in a tech stock and learn it has a beta of 1.5—meaning it carries 50% more risk than the overall market. You might be willing to take on the risk if achieving higher returns is your goal. However, if you're risk-averse, you might avoid this stock in favor of one with less risk and a lower beta value.
Pros and cons of beta
Pros
- Shows an investment's risk level relative to the overall market.
- Helps you determine whether an investment aligns with your risk tolerance.
Cons
- Measures past performance and can't guarantee future results.
- Less meaningful over long periods because risk levels can fluctuate dramatically.
Is alpha or beta a better investing strategy?
When evaluating potential investments, it's a good idea to look at both alpha and beta because they measure risk and return—and can help you decide whether to buy an investment. Still, it's essential to consider other metrics, such as cash flow, debt, dividends, and earnings. That way, you'll have more information to make an informed investment decision. You can use an online broker like J.P. Morgan Self-Directed Investing. to research, place, and manage your investments.
J.P. Morgan Self Directed Investing
J.P. Morgan Self Directed Investing
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INVESTMENT AND INSURANCE PRODUCTS ARE: NOT A DEPOSIT • NOT FDIC INSURED • NO BANK GUARANTEE • MAY LOSE VALUE
Of course, you have options if you don't have the time, interest, or experience needed to pick investments like working with a financial advisor.
TIME Stamp: Past performance doesn't guarantee future results
Keep in mind that alpha and beta are backward-looking. While historical data can provide insight into market trends, it doesn't account for new information or changing conditions. As a result, alpha and beta should be used only as a guide, not as evidence of future performance.
Additionally, beta only measures systemic risk (how an investment responds to market volatility), not how a company is run. To get a complete picture and make the best possible investment decisions, consider other metrics, such as P/E earnings, free cash flow, ROE, and debt-to-equity.
Frequently asked questions (FAQs)
What does alpha mean in investing?
Alpha measures how well an investment performed compared to a related benchmark index, such as the S&P 500. Alpha is also used to evaluate the performance of an actively managed fund versus the market. Alpha values above 0 indicate an investment exceeded the index's returns.
What is smart beta investing?
Smart beta is a hybrid investment strategy that combines a passive investing approach with an active strategy. The goal of smart beta investing is to achieve a positive alpha by beating a benchmark index while keeping beta in check.
While traditional indexes are usually market-weighted (meaning the company's market capitalization determines the weight each stock has within the index), smart beta indexes use alternative approaches. For example, a smart beta index may give equal weight to every stock in the index—or use fundamentally weighted or volatility-based indexes.
Is a higher beta better for stocks?
A higher beta indicates a stock is more volatile than the market and carries more risk—but generally has the potential for higher returns. On the other hand, low-beta stocks typically pose less risk but yield lower returns. Stocks with higher betas are attractive to investors willing to take on more risk in exchange for higher potential rewards. Risk-averse investors will likely find low-beta stocks more suitable for their investment portfolios.
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