Alpha and beta are indicators for evaluating the effectiveness of investments. Alpha measures the performance of an asset or a portfolio relative to the market. Beta measures volatility, i.e. market risk. Both indicators are historical, meaning they depend on the chosen period and do not guarantee results in the future. Let’s consider them in more detail.
What is portfolio beta?
The traditional approach to investing is based on the modern portfolio theory, proposed by Harry Markowitz in 1952. To achieve an optimal portfolio, use a combination of instruments with a weak or negative correlation. Profits from some assets might offset losses from other ones. The beta coefficient is just what you need to assess the risk. It was first introduced by William Sharpe in 1964.
Beta gives an idea of the capriciousness of the price of an individual asset or the entire portfolio relative to the benchmark. The benchmark is usually a stock index for the broad market. For US stocks, the beta is measured relative to the S&P 500 index.
Beta indicates whether the investor has taken on increased risk relative to the broad market.
Here is how one can interpret the beta values:
- Beta < −1. The correlation between the asset and the benchmark is inverse. They move in different directions, while the asset is more volatile.
- −1 < beta < 0. The correlation is still inverse, but the asset is more stable than the benchmark.
- 0 < beta < 1. The asset moves in the same direction as the benchmark but does not fluctuate much. The risk is less than the market one.
- Beta > 1. The asset correlates with the index and is more volatile. It is risky.
Negative beta is relatively rare. You can find beta calculators on the internet.
What is portfolio alpha?
Portfolios often perform better than expected. This excess return is due to the effect of portfolio management - alpha. For example, it could be that the investor correctly determined the entry point and bought the asset at the very bottom. The question is how to separate the investor action factor from the risk premium. Excess returns could also be the result of taking on more risk.
In 1968, Michael Jensen introduced a formula for calculating the risk-adjusted excess return of a portfolio. You don’t need to memorize it.
You can find online calculators on the Internet.
Jensen’s alpha = pr − (rf + b × (rm − rf))
- pr — the portfolio return;
- b — portfolio beta;
- rm — benchmark indicator;
- rf — the risk-free rate.
Higher positive alpha values are a good sign. It means that a portfolio manager has picked the stocks correctly. By contrast, negative alpha suggests the investor fell short in achieving the required return. When the alpha is equal to zero, it means that the portfolio manager has earned a return adequate for the risk taken. The alpha indicator is especially valuable for portfolio managers, as it allows for evaluating work effectiveness.
When calculating alpha, one can also assume the results of other investment factors besides betas, such as dividends or cost factors.
The beta allows you to assess the risk of an investment and understand how volatile an asset or portfolio is as a whole compared to the market. In Markowitz’s portfolio theory, the market is efficient, and the greater the risk of an investment, the higher the expected return. But in reality, beta is unpredictable, and stock returns can be even lower than the risk-free rate. From 2000 to 2009, investors suffered losses from US stocks, which performed worse than bonds and cash.
How can one create a smart investment strategy?
Alpha allows you to measure excess returns relative to a risk-adjusted benchmark. It reflects the successful investing actions together with the well-chosen transactions’ timing. An investor should evaluate the beta when drawing up a strategy to understand the risk of investments and enhance the expected return.
As for alpha, the factor is crucially valuable for professional portfolio managers, but simple investors don’t need it. For example, if an investor buys indices and holds them.