A Beginner’s Introduction to Alpha and Beta

Sometimes it’s the little things that confuse us the most. Often financial jargon has the effect of obscuring the subject rather than opening it up.

So when you hear an analyst on Bloomberg talking about Alpha and Beta, even though you may understand everything else they’ve said, these two little Greek words can occasionally cause you to miss their point.

In the following article we’re going to focus on these commonly used terms, so that by the end you should be able to understand them and apply them to your own investment activities.

The short version

Alpha and Beta are important to both traders and investors because they measure potential risk and reward. Taken together, Alpha and Beta can provide you with useful information about the relative riskiness and projected returns of an asset, an asset class, an index or fund.

Essentially anything with a price feed or a changing numerical value can be compared to a benchmark in this way. Alpha and Beta are useful for determining the relative risk of a potential investment, but also for measuring the performance of your own portfolio.

A is for Alpha

Simply put, Alpha means excess return. When you hear an investment manager talking about his Alpha, he’s referring to the percentage by which his investments outperformed or underperformed. Outperformed or underperformed what? Usually a benchmark index.

In a world where everything is relative, you need some kind of broad and stable measure of economic performance to compare returns against, both your own and those of others. This is the idea behind Alpha.

The most commonly used measure of economic performance is the Standard and Poor’s 500, an index that tracks the value of the largest 500 publicly traded US companies. It’s considered a pretty sound performance benchmark and a proxy for US economic health. When you hear traders talking about “beating the market”, this is usually the market that they’re referring to.

The S&P500 is also extremely popular among passive investors because it tends to go up year after year in all by the most troublesome economic times. So, by investing passively in an index such as the S&P, you’re considered to be protected from the fortunes of individual companies and are more broadly invested in the entire market.

How Alpha works

In its 93 year history the S&P 500 has had 68 up years. During these it has grown by between 0.47% and 43.61%. Why is this important to Alpha? Because if you’re using the S&P 500 as your benchmark and it grows by 5% in a year, then that 5% is a necessarily part your Alpha calculation.

Say your trading account returns you 10% in a year, then your trading activity outperformed the S&P 500 by 5% that year. Meaning that the Alpha on your trading account is 5 for the year. Now, if your account had closed the year 10% down, then your Alpha for the year would be -5. For you to have generated an Alpha of 0, your account would have had to be up 5% for the year, thus matching the performance of the S&P 500.

As you can see, Alpha tells you how risky an investment proves to be relative to a less risky benchmark. So your 10% down year reveals your trading strategy to be riskier than just having passively invested in the S&P 500.

B is for Beta

Where Alpha measures excess return, Beta measures volatility, or the magnitude of the highs and lows an investment undergoes relative to a more stable benchmark. Why is Beta important? Because it’s all well and good to tell someone that your strategy returned 5% more than the S&P 500, but you’re not really giving them the full picture are you?

What about when the S&P dropped? How low relative to the S&P did your investments go then? For a portfolio, or a fund or an individual asset to outperform a benchmark on the way up, it’s also likely to underperform it on the way down. In other words, it’s more volatile.

This is what you use Beta for, to measure how wild an investment’s swings are relative to the benchmark.

How Beta works

Treasury bills are often used as a Beta benchmark owing to their traditional stability, but we’ll keep our benchmark the same as in our previous example. The S&P 500 is up almost 12% this year. The largest drop it experienced in that time was around 7%.

For your portfolio to have a Beta of 1, it would have to experience the same percentage highs and lows as the S&P 500. This would mean that it’s equally as volatile as the S&P 500. Anything over 1 is the percentage by which your portfolio is more volatile than your S&P benchmark. For instance, a Beta of 1.1 would mean that your portfolio is 10% more volatile than the S&P. So when the S&P goes up, your portfolio goes up by 10% more and when it drops your portfolio also drops 10% lower.

On the other hand, a Beta of less than 1 means that your portfolio goes up and down relatively less than the S&P 500. So a Beta of .6 is only 60% as volatile as the S&P 500. In other words, it goes 60% as high on the way up and 60% as low on the way down.

A negative beta means that your portfolio moves in the opposite direction to the benchmark. So a beta of -1 would mean that when the S&P goes up by 10%, your portfolio goes down by 10% and vice versa. This is useful information to know as it allows you to pick assets that are a hedge against certain scenarios.

What to Keep in mind

It’s important to understand that what is desirable as Alpha is not necessarily desirable as Beta in certain situations. For example, as a measure of excess returns, higher Alpha is always more desirable than lower Alpha (and much more desirable than negative Alpha).

However, the same does not hold true for Beta. Your preferred Beta will always depend on your risk tolerance or risk aversion. And these vary greatly from individual to individual. Those who have an appetite for risk will undoubtedly gravitate to investments with high Beta as they seek to generate greater returns and are prepared to endure the risk of larger drawdowns. Risk averse investors, who prefer steady growth that is less vulnerable to pronounced drawdowns, will inevitably choose assets with lower Betas.