Alpha and beta are important tools for many investors when it comes to figuring out if their investments are doing well. So what are they exactly and how do they work? CNBC explains.
What are alpha and beta?
Technically speaking, they are both risk ratios used as statistical measurements for calculating returns.
Translation: Both are designed to help investors determine the risk-reward profile—profits or losses—of an investment portfolio, from individual stocks to mutual funds.
There are differences between the two—even as they sometimes intertwine—as we'll see.
Simply put, Alpha is a measure of an investment's performance compared to a benchmark, such as the S&P 500. It's a mathematical estimate of the return, based usually on the growth of earnings per share.
Beta, on the other hand, is based on the volatility—extreme ups and downs in prices or trading—of the stock or fund, something not measured by alpha. But beta, too, is compared to a benchmark, like the S&P 500. You can think of beta as the tendency of a security's returns to respond to swings in the market.
How are they calculated?
Alpha and beta use formulas that end up looking like a calculus problem.Got your calculators?
The alpha for a portfolio, asset type, goal, or investment type is determined by calculating excess returns from a weighted average of the investments in that group. The weighting is based on the ending value, usually of earnings per share.
For alpha, the formula is:Return = (End_price + Dist_per_share - Start_price) / Start_price.
When calculating the beta of an investment the simple monthly returns over the specified comparison period are calculated. The simple monthly return is: Return = (End_price + Dist_per_share - Start_price) / Start_price.
Both alpha and beta results are then compared to the benchmark—the standard benchmark being the S&P 500.
How do they work?
A positive alpha of 1.0 means the fund or stock has outperformed its benchmark index by 1 percent. A similar negative alpha of 1.0 would indicate an underperformance of 1 percent.
A beta of less than 1 means that the security will be less volatile than the market. A beta of greater than 1 indicates that the security's price will be more volatile than the market.
For example, if a stock's beta is 1.2, it's theoretically 20 percent more volatile—subject to big swings in prices or sales—than the market.
How are they applied?
Investors can use both alpha and beta to judge a manager's—or individual stock's— performance. Investors would most likely prefer a high alpha and a low beta. But other investors might like the higher beta, trying to cash in on the stock or fund's volatility in price and shares sold.
However, if a fund manager or stock has had a high alpha, but also a high beta, conservative investors might not be so happy. That's because the beta might make them withdraw their money when the investment is doing poorly—due to the increased volatility and possible risk of losses indicated by the high beta.