Investing and the way to invest have become quite easy these days and thanks to the rapid increase in technology. Though investing is important to improve the lifestyle, it is equally important to keep an eye on the performance of the investments. Especially, investments like stocks and mutual funds require constant observation. The investors who are new to the investment options like stocks or mutual funds would have heard the terms Alpha and Beta.
The most important key measurement terms used to evaluate the performance of a stock or an investment are Alpha and Beta. Using the Alpha and Beta the key factors of a stock risk and returns are measured.
What is Alpha?
Alpha is the measurement of success in the stock market. It shows how well a stock performed in the market. When there is a hike in the market, it adds a positive impact on stocks and this is called Market Return. However, some stocks outperform by giving higher returns than the market expectations. Alpha is used to calculate the difference by comparing the stock returns with the benchmark (market) index.
Alpha indicates the investor how the stock performed in the past. Alpha results can be positive or negative for a stock. It is clear that a positive value means the stock outperformed while a negative value means the stock didn’t do well and to be specific, it underperformed.
Alpha (a) = Actual Return on a Stock – Expected Returns on a Stock
For example, if the result is 5 then it means the stock beat the market index by 5% and the investor is “seeking positive alpha’. If the result is -1 then the stock underperformed the market index by -1%.
Alpha in the stock market can tell you how the stock performed in the market in the past but can’t depict how it will be performing in the future.
What is Beta?
It is well-known that stocks are considered one of the high-risk investments. Beta is used to find the systematic risk involved in the stock that is the risk that can’t be avoided. With respect to the market, Beta measures the volatility of the stock. And by determining the volatility of a stock, the investor can decide whether the stock is worth the investment.
Beta = Covariance / Variance
Covariance is how two different stocks perform in different market conditions. The positive covariance is that two stocks are in compliance with each other while the negative covariance means the two stocks are going in the opposite direction.
Variance is the deviation of a stock’s price from its average and identifies the price volatility of the stock.
If the beta value is 1 then it indicates that the stock’s price is going along with the market. If it’s more than 1 then it means the stock is more volatile than the market, while a beta less than 1 indicates that the stock is less volatile than the market. In much simpler terms, if the beta value is high (greater than 1) that means the risk is high and the beta value is less then the risk on the stock is less. Here, 1 is considered as the baseline number for Beta in stocks.
Usage of Alpha and Beta measurements
Active investors in stocks can use Alpha and Beta as the stock performance measurements. Alpha can be used to calculate the performance of stock while Beta will be useful in identifying the risk of the stock.
It is ideal that a stock with high Alpha tends to be preferred by investors but it is also said that any stock that performs high at the current time may not do the same in future. And on the other hand, High Beta stocks will go great when the market rises and crashes badly during the downfall of the market. And when the market falls, low beta stocks perform better. An active investor goes for high Alpha stocks while investing while passive investors pick high beta stocks. Though the Alpha and Beta is an individual investor’s decision it is recommended to invest with a conscious mind.