Coming to terms with a lot of the different terms used when you first begin your journey in trading stocks is arguably one of the most complex parts of starting out.
This is why we aim to keep you updated and in the know with all of the information you need to know throughout every step of your journey in trading stocks.
Two terms you’ll hear mentioned frequently are “Alpha” and “Beta”, and while you might know what they mean outside of the context of stocks, you still need to know exactly what sort of meaning they have in this context.
So if you’re new to stocks and are unsure about what these two terms mean, or just want to brush up on your knowledge, then read through our guide to find out everyone you need to know.
Putting it simply, Alpha and Beta are two different measures that are involved with the same equation that has been derived from linear regression.
This equation is used to help explain how different investment funds and stocks are performing.
The excess return on an investment, once you’ve adjusted it for the volatility that is related to the market and the often random fluctuations, is known as the Alpha.
Overall, both Alpha and Beta are forms of measures which can be used to predict and compare returns.
Linear Regression Equation
If you’re not too familiar with algebra, then looking at this equation might confuse you even further. However, if you feel comfortable with algebra, then have a look at this equation, as this is the basic model:
y = a +bx + u
In this equation:
- y is how the stock or fund performs.
- a is the alpha, the excess return of the fund or stock.
- b is the beta, which is the benchmark that the volatility is relative to.
- x is how this benchmark performs, and is often the S&P 500 index.
- Finally, the residual is represented by u, which is the unexplained and random portion of permanence in any given year.
This all might seem too confusing, but don’t worry, we’re going to explain it more in further detail down below, so if you’re not particularly adept at understanding algebra, then we’ll help make it easier to understand!
It’s surprisingly much easier to discuss beta first, before we begin to look at alpha. Beta is seen as a form of measurement of the volatility that is relative to a benchmark.
It’s used in order to measure the systematic risk that a portfolio or security may have when compared to something like an S&P 500 index. Generally, most growth stocks will tend to have a beta that is over 1, in fact, it’s usually much higher than this.
A Treasury Bill (T-Bill), would have a beta that is near to zero, as its price moves very little in comparison to the rest of the market.
Beta is also a multiplicative factor. For example, a 2X leveraged S&P 500 ETF will have a beta extremely close to 2, which is relative to the S&P 500 as a result of its design. Therefore, it will go up or down by twice as much as the index in any given period of time.
Alternatively, if the beta is -2, it will move in the opposite direction to that of the index by a factor of 2. Investments that feature negative betas tend to hold treasury bonds, or inverse ETFs.
The beta is an indicator that the risk held by a security or stock cannot be diversified away, and shows the market risk.
The alpha is defined as the excess return on an investment once you have adjusted for market volatility and random fluctuations.
In addition to this, alpha makes up part of the five risk management indicators, for mutual funds, bonds, and stocks. Essentially, it is able to inform investors whether an asset has performed better or worse than the beta had predicted.
If an asset has an alpha of -15, then the investment is considered much too risky given the return. If it has an alpha of 0, then the asset has provided a return that was equivalent to the risk.
If the alpha is greater than zero, then the investment in that asset has outperformed once it has been adjusted for volatility.
When comparing the returns of an investment, it’s also important to consider what index you’re using to compare them with, with many people instantly using the S&P index, but in reality, this might not be the correct index to be using.
For example, if investing in small cap value stocks, these stocks tend to have higher returns than the S&P 500, which means that the correct index to be used would be a small cap value index, which would provide a much better benchmark than the S&P 500 would.
Small sample size is often a problem when it comes to evaluating an investor’s alpha, and very few of them have a true alpha.
In reality, it can sometimes take upwards of a decade to be able to determine whether or not it has a true alpha. So you should take caution if you happen to see an investor bragging about having a particularly high alpha.
To summarise, both alpha and beta are a form of risk ratios, which can be used by investors to help predict and compare results.
They’re incredibly important, so you should become comfortable knowing what they mean, but you should also ensure that you learn exactly how they are calculated, as it’s a difficult process that can be easy to get confused on!
So just be sure that you learn how to do it properly.