Alpha and beta are two common measurements of investment risk. However, I must add a caveat before we jump in.
Alpha and beta are part of modern portfolio theory, much of which is questioned by analysts (including myself). That doesn’t mean you can’t use the concepts of alpha and beta to have a better understanding of investing.
First we will examine Alpha and beta. Then we will look at how a value oriented investor can approach these two investment concepts and become a better investor.
Difference Between Alpha and Beta
Beta is a historical measure of volatility. Beta measures how an asset (i.e. a stock, an ETF, or portfolio) moves versus a benchmark (i.e. an index).
Alpha is a historical measure of an asset’s return on investment compared to the risk adjusted expected return.
What Does Beta Mean?
A beta of 1.0 implies a positive correlation (correlation measures direction, not volatility) where the asset moves in the same direction and the same percentage as the benchmark. A beta of -1 implies a negative correlation where the asset moves in the opposite direction but equal in volatility to the benchmark.
A beta of zero implies no correlation between the assets. Any beta above zero would imply a positive correlation with volatility expressed by how much over zero the number is. Any beta below zero would imply a negative correlation with volatility expressed by how much under zero the number is.
For example a beta of 2.0 or -2.0 would imply volatility twice the benchmark. A beta of 0.5 or -0.5 implies volatility one-half the benchmark. I use the word “implies” because beta is based on historical data and we all know historical data does not guarantee future returns.
What Does Alpha Mean?
Alpha is used to measure performance on a risk adjusted basis. The goal is to know if an investor is being compensated for the volatility risk taken. The return on investment might be better than a benchmark but still not compensate for the assumption of the volatility risk.
An alpha of zero means the investment has exactly earned a return adequate for the volatility assumed. An alpha over zero means the investment has earned a return that has more than compensated for the volatility risk taken. An alpha of less than zero means the investment has earned a return that has not compensated for the volatility risk assumed.
By risk adjusted we mean an investment return should compensate for beta (volatility). According to Modern Portfolio Theory if an investment is twice as volatile as the benchmark an investor should receive twice the return for assuming the additional volatility risk. If an investment is less volatile than the benchmark an investor could receive less return than the benchmark and still be fairly compensated for the amount of volatility risk taken.