Alpha & Beta: Smart Investment Tools Showing Reward vs Volatility

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Investors can use alpha and beta to analyse the return and volatility of an investment, based on past performance. These financial risk ratios are both compared to a benchmark index such as the S&P 500 (which provides exposure to the market risk premium),

Beta measures how volatile a stock or portfolio is relative to a benchmark index, using historical market data. Beta is based to 1, where a value of 1 means an asset or fund will move exactly in line with the benchmark’s gains and losses. Anything more than 1 suggests the fund tends to be more volatile than the benchmark, while a result of less than 1 means its performance has been more stable in relative terms.

Alpha, meanwhile, measures an asset’s return relative to a benchmark. Based at zero, a positive alpha value indicates that an investment has yielded returns which have beaten the benchmark – in other words, it can mean the asset’s volatility risk has paid off.

Since investors have different attitudes towards risk, or volatility, there are no standard alpha or beta preferences within investment markets.

Many investors prefer a high alpha (or returns in excess of the benchmark’s returns) alongside a low beta (implying that their investment is less volatile than the benchmark). This infers returns above market returns without the high volatility risk of large upward or downward swings in performance.

But investors with a greater risk appetite might prefer a high alpha and high beta, where a higher beta ratio means even greater returns can be gained amid periods of upside volatility. Put simply, that entails buying a fund in the market when it is undervalued and selling when it is expensive.

However, the risk is that buying and selling at the wrong times would lead to bigger losses than would be the case if an investor had bought the benchmark instead. That means more conservative investors in the market would likely shy away from a high-beta investment, even if a positive alpha indicates probable compensation for risks taken.

Used together, alpha and beta can let investors know whether or not they have been – or are likely to be – adequately compensated for an asset’s volatility risks.

Important to note, however, is that alpha and beta are calculated based on historical market data, meaning they are no guarantee of future returns or volatility.

Another useful performance indicator is the Sharpe ratio, which measures the price attached to risk, or how much risk premium an investor needs on a per-unit of risk basis.

As an example of how alpha and beta can be used to assess performance relative to a benchmark, consider a fund with a beta value of 1.5. This implies that it should be 50% more volatile than the benchmark, in this case the S&P 500 Index, based on historical performance.

A 10% return on the benchmark should result in a 15% return from the fund, and a healthy 5% alpha, since the investment beat the S&P 500 by that amount.

But despite possible excess return, or compensation for volatility risk of 5%, a slightly risk-wary investor might not feel comfortable with being exposed to a volatile basket of funds, given the high downside risks associated with a beta of more than 1.

On the other hand, in the case of beta being less than 1 (meaning the asset tends to be less volatile than the benchmark), risk-averse investors may actually even be content with a negative alpha – or returns which are less than the benchmark. This is because the portfolio of funds can be regarded as a “safe” investment relative to the benchmark, meaning the portfolio could be attractive when a financial market is in a state of flux.

However, consistent underperformance relative to the benchmark is likely to put many investors off an asset, while a negative alpha for an entire portfolio could imply a lack of diversification.

Alpha and beta are helpful in assessing the performance of an asset or portfolio relative to a benchmark, which in turn helps to compare two or more investments. If multiple assets are measured against the same benchmark, then knowing their alpha and beta ratios assists an investor in making the right selection. In essence, alpha and beta help investors screen markets and hone in on the stocks or funds which match their risk profiles.

The measure of a quality investment strategy, or portfolio fund manager, is therefore one which can consistently attain positive alpha, requiring accurate forward-looking analyses as well.

Meanwhile, since alpha is based on targeting specific risks, different sources of alpha are not necessarily correlated to one another, even in times of crisis. By blending two or more alpha sources, investors can spread risk across their portfolios.