When investing, your capital is at risk and you may get back less than invested. Past performance doesn’t guarantee future results.
Alpha vs. Beta in Investing Performance: Definition, Examples, Pros & Cons
Understanding the difference between alpha and beta gives you a new way to understand the true source of investing results, be it the specific selections you have made or the broader market.
Big ideas
- In investing, alpha and beta are complementary performance indicators that relate an asset’s growth and volatility to a suitable benchmark.
- Beta, alpha and beta coefficients are mathematically defined and based on publicly available information; they can’t be fudged, fabricated, or misconstrued.
- However, when it comes to interpreting alpha and beta, market conditions must still be taken into account. These numbers provide a useful snapshot of an investment – but only a partial one, based solely on past performance.
QUOTE
"The stock market is filled with individuals who know the price of everything, but the value of nothing."
“You don’t know what you can’t measure” is kind of a truism in investing. Hard data is almost universally preferred to gut feelings, astrology, and what some guy told you at the pub!
Not everything is quantifiable, of course: the skill of a company’s management team or the “attractiveness” of a new product line can, at best, be estimated. When measurable information is available, though, it pays to have a framework you can use to analyze figures in a consistent, rational way.
This is why professional investment managers are always talking about alpha vs beta. Finance is inherently complex: reducing a large data set to a few simple numbers greatly facilitates communication. Indicators like alpha and beta make it easier to get a grip on a stock without spending hours on research.
Once you understand the dynamic of alpha vs beta, investing becomes less of a Gordian knot … though these two numbers certainly aren’t the only factors you should be tracking. Nothing substitutes for fundamental analysis and keeping an eye on the news.
Not everything is quantifiable, of course: the skill of a company’s management team or the “attractiveness” of a new product line can, at best, be estimated. When measurable information is available, though, it pays to have a framework you can use to analyze figures in a consistent, rational way.
This is why professional investment managers are always talking about alpha vs beta. Finance is inherently complex: reducing a large data set to a few simple numbers greatly facilitates communication. Indicators like alpha and beta make it easier to get a grip on a stock without spending hours on research.
Once you understand the dynamic of alpha vs beta, investing becomes less of a Gordian knot … though these two numbers certainly aren’t the only factors you should be tracking. Nothing substitutes for fundamental analysis and keeping an eye on the news.
What are alpha stocks?
Investors are often told to minimise risk while maximising rewards. This is good advice, much like "eat your vegetables". It’s of limited use, however, without any way to put these concepts into numbers. Beta, alpha, and a few other Greek letters can give investors the equivalent of “five-a-day” rules of thumb they can put into practice.
Alpha’s definition in finance relates to the “rewards” part of the equation. In simple terms, it places a numeric value on a stock’s tendency to outperform the market as a whole. It’s the “edge” a particular investment or portfolio has over the average of comparable assets. In other words, a higher-alpha investment yield returns that aren’t the result of the market as a whole increasing in value.
Alpha’s definition in finance relates to the “rewards” part of the equation. In simple terms, it places a numeric value on a stock’s tendency to outperform the market as a whole. It’s the “edge” a particular investment or portfolio has over the average of comparable assets. In other words, a higher-alpha investment yield returns that aren’t the result of the market as a whole increasing in value.
Example of alpha
The red section traces the performance of our chosen benchmark (perhaps the FTSE 100) as a ‘baseline’ performance an investor might expect. The yellow shows a portfolio that includes high-alpha stock prices, which rise faster (by 25 basis points) than average. The pink section represents an even higher alpha set of investments that rise even faster (by 50 basis points). When an investor retires, the difference in alpha can make a substantial difference to expected spending power.
Formula for alpha
Calculating a share’s or fund’s alpha is child’s play:
FORMULA
α =Ri - Rm
Where Ri is the investment’s return, and Rm is that of the market (or other index) during the same period.
Where Ri is the investment’s return, and Rm is that of the market (or other index) during the same period.
If, for example, a certain stock has grown by 15% in a year while the market as a whole managed 10%, that means its alpha is 0.05 or 5%. Another stock that returned only 7% will have an alpha of -0.03 or -3%.
Note: There also exists a related concept called Jensen’s alpha, which explicitly takes a stock’s volatility into account. The two terms (alpha and Jensen’s alpha) are often used interchangeably. People also tend to state alphas of either type as percentages without using the “%” sign, which sometimes causes confusion.
Note: There also exists a related concept called Jensen’s alpha, which explicitly takes a stock’s volatility into account. The two terms (alpha and Jensen’s alpha) are often used interchangeably. People also tend to state alphas of either type as percentages without using the “%” sign, which sometimes causes confusion.
FORMULA
α(Jensen)=Ri - Rf+β(Rm-Rf)
Where Ri is the investment’s return, Rm is that of the market, and β is the beta coefficient defined below.
Rf is a theoretical value known as the “risk-free rate of return”; in practice, it can be obtained by subtracting the inflation rate from the returns of government bonds.
Where Ri is the investment’s return, Rm is that of the market, and β is the beta coefficient defined below.
Rf is a theoretical value known as the “risk-free rate of return”; in practice, it can be obtained by subtracting the inflation rate from the returns of government bonds.
One point to always remember is that alpha coefficients only make sense when comparing investments with similar risk profiles. If, for example, you used the FTSE 100 as a benchmark for a portfolio heavy on tech stocks, you may fool yourself into thinking it has achieved a fantastic alpha number. This would be misleading, though, as technology investments are riskier and more volatile than the FTSE 100. The first step in knowing how to find the alpha would be to choose a more appropriate index, such as the FTSE techMARK.
So, what are alpha stocks exactly?
All shares, and indeed other types of securities, have their own alphas. You may also see the terms “alpha companies” or “alpha investment strategy” thrown around. These terms refer to attempts or opportunities to beat the market’s rate of return by putting money into carefully selected high-alpha investments.
Of course, this is easier said than done. In practice, it also means exposing your capital to so-called idiosyncratic or specific risk, which connotes the possibility of a particular security losing value regardless of what’s happening in the financial market as a whole. Alpha investment strategies, therefore, normally include measures to hedge against idiosyncratic (company-specific) risk.
Of course, this is easier said than done. In practice, it also means exposing your capital to so-called idiosyncratic or specific risk, which connotes the possibility of a particular security losing value regardless of what’s happening in the financial market as a whole. Alpha investment strategies, therefore, normally include measures to hedge against idiosyncratic (company-specific) risk.
Shouldn’t we all just be chasing stocks with higher alphas, then?
Whether in politics, investing, or even plumbing, looking for simple solutions to complex problems isn’t always the right approach (and may be fruitless anyway). It’s certainly tempting to think that, once armed with the alpha definition, finance suddenly becomes easy. But this is only somewhat true.
Pros of high alpha
✔️ Calculating (or, more commonly, looking up) a stock’s alpha is easy and straightforward. You’ll be able to quickly weed out unsuitable investment options if high returns are what you’re after.
✔️ In a growing market, many smaller companies tend to outperform the market. The stocks with high alpha coefficients will usually generate higher returns but also carry greater risk.
✔️ In a growing market, many smaller companies tend to outperform the market. The stocks with high alpha coefficients will usually generate higher returns but also carry greater risk.
Cons of high alpha
❌ Because this metric is so widely used, identifying high-alpha companies brings only temporary success. Assuming that a stock’s winning streak continues, other investors who know the formula for alpha will buy up more shares, meaning that the stock’s competitive edge will soon be “priced into” its market value.
❌ What are the alpha stocks of yesterday going to do tomorrow? Outperforming the market in the past, especially over a short period, is no guarantee that an investment won’t experience an equally sharp decline in the future. If the market as a whole goes into a slump, defensive stocks with traditionally low alphas may offer better returns.
❌ What are the alpha stocks of yesterday going to do tomorrow? Outperforming the market in the past, especially over a short period, is no guarantee that an investment won’t experience an equally sharp decline in the future. If the market as a whole goes into a slump, defensive stocks with traditionally low alphas may offer better returns.
In short, selecting investments is never just a matter of weighing alpha versus beta. Diversity in your portfolio, along with other tried-and-true investment lessons, should still be at the forefront of any investor’s mind.
What are beta stocks?
Whereas alpha focuses on returns (specifically, how much alpha stocks exceed those of similar investments), beta is all about risk. Yet beta is not simply the opposite of alpha. These terms have very different but complementary meanings. If you know both a stock's alpha and beta, you already have a pretty good idea of what to expect from it even if you don't know anything else about the company.
Like alpha, beta is a historical measurement based on an investment’s past performance. It, too, uses an index or other benchmark as a basis for comparison. The difference between alpha and beta is that gains are all that matter for alpha, whereas beta only tracks fluctuations in value without regard for eventual returns.
Like alpha, beta is a historical measurement based on an investment’s past performance. It, too, uses an index or other benchmark as a basis for comparison. The difference between alpha and beta is that gains are all that matter for alpha, whereas beta only tracks fluctuations in value without regard for eventual returns.
Example of beta
All stocks (and other kinds of assets) change value at different rates. Taking the blue line as the benchmark, stable shares like the green line don’t move as much – they have low betas. Others, like the red line, are more volatile than the market as a whole, and their beta coefficients are high. As the chart demonstrates, it makes sense to own high-beta stocks at the beginning of a new bull market and own low-beta stocks at the start of a new bear market.
In the hypothetical graph above, all shares rise and fall in tandem with the market as a whole. The key to understanding beta (versus alpha especially) is that this needn’t be the case. An asset with a high beta does not necessarily change its value in lockstep with the benchmark. Over time, the two will usually follow the same trends, but any stock may fall while the index to which it’s most closely related rises, or vice versa.
Formula for beta
It’s rarely necessary to calculate betas and alphas yourself; many investment websites and tools have beta listings available for all publicly traded stocks. If you’re mathematically inclined, the following formula for beta may be of interest; if not, just look at it once and then forget it forever.
FORMULA
Beta (β) = Covariance / Variance
where:
Covariance measures how a stock's return moves relative to the market's return.
Variance measures how the market moves relative to its mean.
The beta (β) of an asset is calculated by dividing the covariance of the asset's return with the benchmark's return by the variance of the benchmark's return over a specific period.
where:
Covariance measures how a stock's return moves relative to the market's return.
Variance measures how the market moves relative to its mean.
The beta (β) of an asset is calculated by dividing the covariance of the asset's return with the benchmark's return by the variance of the benchmark's return over a specific period.
Understanding beta (vs alpha)
First, investment beta is a bit more complicated than investment alpha, which is a pretty intuitive concept. If, for instance, a stock has α = 0.02 and the market gains 10%, that stock’s value can be expected to rise by 12%. Here are a few factors that illustrate why the beta is more complicated:
- The beta of the index used, by definition, is always 1.
- A portfolio invested largely in blue-chip stocks will have a beta of close to 1. (Since indices such as the FTSE 100 are weighted averages, large-cap companies have a proportionate effect on their values).
- As shown in the formula for beta, cash has a beta coefficient of zero. Whatever happens to the stock market, the value of cash (in pounds and pence, ignoring inflation) stays the same.
- Small-cap and tech stocks are more sensitive to changes in market conditions and usually have betas larger than one. With a high beta, stock prices are more mobile. If a stock has β = 2 and the market rises (or falls) by 10%, those shares should gain (or lose) about 20%.
- Larger, established companies tend to be more stable, as do sectors like manufacturing. These stocks usually have betas lower than one and stable share prices.
- Betas are sometimes calculated for non-share investments, such as precious metals and bonds, using an index based on the stock market. This is meant to be illustrative rather than analytical, though. Beta and alpha don’t allow you to directly compare apples with oranges.
So, what are beta stocks exactly?
Since beta is a measure of volatility, it’s often used as an estimator for risk. In investing, beta and alpha are not exact synonyms for “risk” and “returns”, though they’re sometimes used as a kind of shorthand for these concepts. Beta is more about volatility: with a high beta, stock prices can go dramatically up as well as down. The potential upside is obviously not equivalent to the possibility of taking a loss, though the formula for beta treats these in exactly the same way as long as they’re in line with market trends.
A more accurate way of describing beta relates to exposure – specifically to systematic or market risk. An investment strategy based on beta (vs alpha) can help a broker structure a portfolio in such a way that a client’s exposure to ordinary market fluctuations is quantified. Any given tolerance for risk can be reliably accommodated.
Outperforming the market is not the priority when you’re focusing on beta coefficients. Alpha stock prices can offer greater gains, but also carry idiosyncratic risks that a beta strategy seeks to limit. Beta funds tend to be more passively managed, tracking an index rather than actively hunting for promising companies.
A more accurate way of describing beta relates to exposure – specifically to systematic or market risk. An investment strategy based on beta (vs alpha) can help a broker structure a portfolio in such a way that a client’s exposure to ordinary market fluctuations is quantified. Any given tolerance for risk can be reliably accommodated.
Outperforming the market is not the priority when you’re focusing on beta coefficients. Alpha stock prices can offer greater gains, but also carry idiosyncratic risks that a beta strategy seeks to limit. Beta funds tend to be more passively managed, tracking an index rather than actively hunting for promising companies.
Practical investing: alpha vs beta shortcomings
An asset's alpha and beta are important metrics. They should be seen for what they are, though: understanding them doesn't quite turn you into a skilled quantitative analyst.
Many mathematical tools are available to investors. The key to using them effectively is to realise that, like all statistical summary measures, alpha vs beta in investing doesn’t tell the whole story. It’s important to resist the temptation of inspecting a few trees in detail while ignoring the forest.
Many mathematical tools are available to investors. The key to using them effectively is to realise that, like all statistical summary measures, alpha vs beta in investing doesn’t tell the whole story. It’s important to resist the temptation of inspecting a few trees in detail while ignoring the forest.
QUOTE
“Investors should be sceptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the models. Beware of geeks bearing formulas.”
A stock’s alpha and beta clarify the past but don’t predict the future
Share prices tend to reflect changes in underlying business conditions before these show up in a stock's alpha and beta. For these metrics to be meaningful, the basic business environment needs to remain roughly constant. Both need to be taken with a grain of salt if, for instance, a company that relies heavily on imports or exports is affected by Brexit or a technology the company needs to adapt to changes in its competitors' strategies.
Credit Suisse’s share price and beta up to its recent collapse. The beta coefficient was indeed high for a bank, but that alone didn’t predict catastrophe.
Past performance doesn’t guarantee future results.
Alpha and beta both become more trustworthy indicators as more time passes. As we just mentioned, though, this implies that both the company in question and its market don’t undergo any major changes during the time period its alpha and beta are measured. Taking on more debt, acquiring another company, or changing the business’s focus will all render its alpha and beta coefficients virtually meaningless.
Alpha and beta both become more trustworthy indicators as more time passes. As we just mentioned, though, this implies that both the company in question and its market don’t undergo any major changes during the time period its alpha and beta are measured. Taking on more debt, acquiring another company, or changing the business’s focus will all render its alpha and beta coefficients virtually meaningless.
Alpha and beta ignore business fundamentals
Value investors – those who focus on a company’s inherent worth rather than its share price ( especially if the latter is lower than the former) – usually don’t pay much attention to alpha vs beta. Finance and stock prices, to them, are a kind of abstraction of what a business actually does and are not intrinsic indicators of its value.
As these investors might point out, a stock that's recently suffered a steep decline will have negative alpha and high beta, making it a bad investment in that sense. However, the company may equally well be due for a rebound – again, alpha and beta do not tell the whole story.
As these investors might point out, a stock that's recently suffered a steep decline will have negative alpha and high beta, making it a bad investment in that sense. However, the company may equally well be due for a rebound – again, alpha and beta do not tell the whole story.
Both metrics are tied to the market (or another index)
Choosing an inappropriate benchmark can lead to meaningless numbers. Whatever index is selected as a baseline when calculating alpha, for instance, should be commensurate in risk to the investment. Mutual funds and their managers like to keep score of their relative performances in terms of alpha, but this only makes sense if their portfolios carry similar levels of risk. (Beta, though a good first approximation, isn’t a perfect estimator of downside exposure.)
Beta measurements are often used as part of a diversification strategy. This is all well and good as far as it goes – the whole point of using beta in investing is to minimize the unsystematic risk associated with individual investments. Getting caught up in the numbers, however, can also disguise excessive exposure to a particular sector if the wrong benchmark is used.
Calculating either alpha or beta for a diversified portfolio, including stocks, bonds, gold, real estate, and perhaps other alternative investments, gets pretty tricky. This, too, is because of the difficulty of selecting an appropriate index for each class of investment.
Beta measurements are often used as part of a diversification strategy. This is all well and good as far as it goes – the whole point of using beta in investing is to minimize the unsystematic risk associated with individual investments. Getting caught up in the numbers, however, can also disguise excessive exposure to a particular sector if the wrong benchmark is used.
Calculating either alpha or beta for a diversified portfolio, including stocks, bonds, gold, real estate, and perhaps other alternative investments, gets pretty tricky. This, too, is because of the difficulty of selecting an appropriate index for each class of investment.
Recap
A little bit of knowledge can be a dangerous thing. We all tend to prefer simple explanations for complex phenomena.
Easily measurable facts like percentage returns of a stock or earnings growth can mask the wider context. When you look at stocks’ performances in terms of alpha and beta, markets do make a little more sense. Both of these metrics are just tools, though. Like a screwdriver or hammer, each does one specific thing and should not be applied to jobs for which they’re not suited.
Easily measurable facts like percentage returns of a stock or earnings growth can mask the wider context. When you look at stocks’ performances in terms of alpha and beta, markets do make a little more sense. Both of these metrics are just tools, though. Like a screwdriver or hammer, each does one specific thing and should not be applied to jobs for which they’re not suited.
FAQs
Q: What is a good alpha for a stock?
Any alpha value over zero can be regarded as “good” and indicates that an investment has been doing better than those with similar risk profiles. Past success doesn’t always equate to future returns, though. Stocks that have maintained a high alpha number for an extended period while still showing acceptable performance across other investment metrics are very, very rare.
Q: Is a negative alpha a good buy?
A single technical indicator dipping into unfavourable territory can be cause for concern, but it’s not necessarily a fire alarm. Both alphas and betas change all the time. Investors who follow a buy-and-hold strategy won’t track these numbers on a daily or weekly basis. In the short term, all a negative alpha really indicates is that more shares are being sold. The intrinsic value of the stock may remain unchanged, just as higher alphas could indicate that a company is currently overvalued. Yet a consistently negative alpha is a major warning signal, indicating that the underlying business may be in trouble.
Q: What is a good beta in investing?
Beta comes in two basic flavours: one for an individual investment and the other for a portfolio as a whole. Adventurous investors could be happy with a portfolio beta of well above 1, meaning one that fluctuates in value much more rapidly than the market. Someone close to retirement, on the other hand, may prefer a not-so-volatile portfolio beta of less than one – that is, one which preserves value at the expense of potential returns. Both kinds of portfolios, however, may include specific high-beta stocks: beta only measures one kind of risk, and other metrics may indicate these to be good buys.
Q: What does an alpha value of 0.05 mean?
The formula α = 0.05 simply states that a particular investment recently grew 5% faster than the market as a whole, or perhaps a financial index that more closely relates to the investment. Stock in a medical company, for instance, may be best compared to the FTSE 350 Pharmaceuticals & Biotechnology index. The source supplying the number will usually specify the benchmark used and the period of time in question, as well as indicate whether they show alpha as a number or percentage (i.e., 5% vs 0.05%).
