Straight Talk

Are alpha and beta Greek to you? Risk ratios explained

'Alpha' and 'beta' risk ratios explained

The terms alpha and beta are both associated with the risk ratios that investors use as a tool to calculate, compare and predict returns.

You will most likely see alpha and beta referenced with mutual funds, according to Mark Cortazzo, a certified financial planner and a senior partner at MACRO Consulting Group. Additionally, both measurements utilize benchmark indexes, such as the S&P 500, and compare them against the individual security to highlight a particular performance tendency, he explains.

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While these risk ratios cannot always accurately predict future results, alpha and beta help to differentiate between good and bad investments over a given period of time.

Alpha is perceived as a measurement of a portfolio manager's aptitude. Alpha measures the return that comes from investing in a single security or investment class. Meanwhile, beta gauges the volatility of a specific security by comparing it to the performance of a related benchmark over a period of time. Beta measures the return generated from a portfolio that can be attributed to overall market returns.

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The baseline number for alpha is zero, which is when the investment performed exactly to market expectations. However, the baseline number for beta is one. A beta of one is an indication that the security's price moves exactly as the market moves, Cortazzo explains. If the beta is less than one, the security experiences less severe price swings than the market. Conversely, a beta above one means that the security's price has been more volatile than the market as a whole, he says.

As an investor, it's very important to take the time to get a grasp of financial strategies, Cortazzo says.

Always consider what you want to accomplish with your money and how your investment portfolio fits into the overall financial plan, Cortazzo advises.

Maintaining a good understanding of financial terminology will help you better determine how an asset will fit into your financial needs and thus aid you in building a strong investment portfolio.