Understanding the numbers behind an investment can be what sets apart a successful portfolio from a depreciating one. Among the key data that successful investors use to build portfolios are alpha and beta.
Both alpha and beta are measurements used to compare securities and determine whether they are suitable for a particular portfolio or investor. Each is calculated using the historical performance of the underlying equity. The main difference between the two is that alpha is used to identify performance relative to an index, while beta identifies volatility relative to an index.
What’s the Difference Between Alpha and Beta?
|Measures investment performance||Measures the volatility of an investment|
|Helps you identify the best performing investment funds||Helps you identify an asset’s volatility|
Alpha and Beta Measurements Compared
Alpha is often used to compare mutual funds. If you want to know how a mutual fund has performed in the past compared to the S&P 500 index, you can use the alpha to measure whether the fund overperforms or underperforms.
Alpha is calculated by taking the return on investment of the mutual fund and subtracting from it the return on investment of the respective index, in this case, the S&P 500. A positive alpha means the fund has historically performed better than the index, a negative alpha means the fund has historically performed worse than the index, and an alpha of zero means the fund may have the same expected return as the index.
Beta differs from alpha in that it’s used to measure how risky or volatile a stock is in comparison to an index like the S&P 500, for example.
A higher beta means a riskier investment with the potential of higher returns, while a lower beta means a more conservative investment with lower expected returns.
A beta of 1.0 means the asset has the same volatility as the index. If the beta is 1.2, it indicates that the investment is 20% more volatile than the index. If the beta is 0.8, it indicates that the investment is 20% less volatile than the index.
Which Is Right for You?
Let’s say your goal is to invest in mutual funds and you want to select the fund that has consistently outperformed the overall stock market. You would refer to the alpha of a mutual fund to determine how well it performs and compare it to the alpha of the S&P 500, then pick the best fund. Investors can refer to an investment’s alpha to:
- Compare mutual funds against the performance of an index
- Select the best mutual fund for his or her investment objectives
- Rank different types of investments
If you are someone who doesn’t like volatile investments, you’d use the beta to help find investments that meet your comfort zone. Investors can refer to an investment’s beta to:
- Compare the risk of an investment to an index
- Align their investments with their overall risk tolerance
- Estimate the volatility of an investment as compared to an index
Alpha and beta are rarely used apart from other analysis tools to determine a suitable investment. Rather, both are often used in conjunction with other technical and fundamental analytics.
When using alpha or beta in your strategy, be sure to consider the fact that each measurement is based on the historical performance of a security. This means that neither measurement can predict the future movement of a stock or fund.
The Bottom Line
Alpha and beta are both measurements used by investors to compare the performance and volatility of an underlying security. Alpha helps investors measure the performance of a fund in comparison to an index or another fund. Beta helps investors determine the volatility of a security in comparison to an index so they can further align their investments with their risk tolerance.
When using alpha and beta, keep in mind that the measurements are based on historical data and do not indicate the future movement of a stock or fund. Alpha and beta are often used in conjunction with other ratios or measurements to select investments that fit a particular investment objective.