The not-so-fun thing about being a novice investor is the plethora of opaque investment industry jargon. Take the terms “alpha” and “beta”: aside from being elements of many sorority names, they have little meaning to the layperson. However, as an investor, familiarity with these key concepts will help you understand an investment’s performance and its risk level. The ability to assess the risk-versus-reward qualities of mutual funds and stocks makes you more adept at building a portfolio that suits your investment needs, while avoiding undue risk.
You may have heard the term “alpha” used in reference to dogs or male monkeys, which connotes a sense of dominance or superiority. In a similar sense, in the investment world, alpha is a measure of the relative performance of a stock or mutual fund as compared to its relevant benchmark (the performance of the overall market). Another way to think of alpha is that it is a measure of added value. If a fund’s average returns were the same as the market’s for a given time period, it wouldn’t be adding much value to your portfolio that you couldn’t otherwise get from investing in the entire market (e.g. through an ETF). The important point to note here is that for the same return, investing in the single stock is more risky than investing in its benchmark index. Why take on the additional risk if you don’t have to?
If the fund’s average returns were higher than the market’s returns, it would be said to have a positive alpha. A positive alpha of 1.0 means the stock has outperformed its benchmark index by 1%. Correspondingly, it’s possible to have negative alpha. For example, an alpha of -1.9 would indicate an underperformance of 1.9%.
Beta is a measure of a stock’s volatility (the degree to which the price rises and falls over time) relative to that of the market. Said a different way, beta measures the riskiness of an investment as compared to the overall risk inherent in the market:
· A stock with a beta value of 1.0 is expected to have the same volatility as the market (the market is always a beta of 1.0). For example, if the market appreciated by 6%, the stock price will likely have appreciated at the same rate.
· A beta value greater than 1.0 indicates that the stock’s price tends to fluctuate more than the market. For example, if an investment has a beta of 1.5 and the market fell by 10%, the higher beta would amplify that loss by 15%.
· For beta values less than 1.0, the stock’s price would be expected to move by a lesser degree than the market.
· A negative beta indicates the degree to which the stock’s price moves in the opposite direction to the market. This means that in times when the market goes up, the investment’s value (if it remains true to form) may well move down. Likewise when the market goes down, the investment’s value might be expected to appreciate.
Although it sounds like you’d want to avoid investments with a negative beta value, it isn’t actually a bad thing. This is because investments that move opposite to market movements can reduce a portfolio’s riskiness. The most common example of an investment that tends to move in opposition to the market is gold bullion. The price of gold is inversely related to national and global economic conditions: in good times, the price of gold drops; in bad times, the price of gold rises. So understanding beta allows you to reduce the risk in your portfolio should markets not perform well.
It’s important to keep in mind that both alpha and beta are lagging indicators. That is to say, the interpretation of alpha and beta is like looking in the rear view mirror: they only show what has already happened, and they don’t guarantee that an investment will perform the same way in the future. Like all other tools in your arsenal, these measures have their limitations, so use them in combination with other data before making an investment decision.
While intimidating at first, alpha and beta are relatively tame creatures that offer useful information that can help you to build a balanced, low-risk investment portfolio. By reducing risk, you even out the highs and lows that are inherent in market cycles, making the road in your investment journey a little less bumpy.