What Are Alpha And Beta In Investing?

As their names would imply, alpha and beta are fundamental terms in the investing world.

In its most popular understanding, alpha represents the excess return on a particular investment—a stock, mutual fund or exchange-traded fund—over a relevant index. In other words, if an investor has managed to outperform a certain index, such as the S&P 500, it is said he or she has achieved "alpha."

Beta, by contrast, measures an asset's historic volatility relative to a market benchmark, such as the S&P 500, which has an alpha and a beta of 1.0 because it is considered to be a proxy for the overall stock market. If a stock or fund's beta is 2, for example, that means that it has historically been twice as volatile as the benchmark index, while a beta below 1.0 would indicate that is less volatile than the market.

The simplest way to differentiate between alpha and beta is to remember that alpha measures relative performance while beta measures relative volatility risk.

Let's look at alpha first.

Alpha

Alpha is not simply a measurement of whether and by how much a certain stock or fund beat a particular index. Rather, it takes into account how much risk the investor or manager took on in order to achieve alpha. Importantly, alpha measures an asset's return against the benchmark's risk-adjusted return.

An investor may have outperformed the desired benchmark in terms of simple arithmetic. For example, Mutual Fund A returned 15% last year, while the S&P 500 returned 10%. On its face, it looks like the fund beat the S&P by five percentage points.

However, if the fund was five percentage points more risky than the overall market, then the investor took on more risk than needed to obtain the same result compared to the market. Likewise, if the asset is less risky than the index, the investment could underperform the benchmark in simple numbers but still be considered a good investment because less risk was taken on.

If an asset is twice as risky as the benchmark, then the investor should expect to receive twice the return because of the additional risk taken on.

Beta

While alpha measures the relative return on an investment compared to a benchmark, beta measures the asset's historic price volatility relative to the index.

As with alpha, the S&P 500, by virtue of its being generally accepted as a proxy for the overall stock market, has a beta of 1.0. That being the case, a stock or fund with a beta of less than 1.0 would be less volatile than the overall market, while an asset with a beta above 1.0 would be more volatile. For example, if a stock's beta is 1.3, then it's 30% more volatile than the broad market.

Utilities, financials and other equities that pay high dividends are generally considered to be less risky than the overall market because the payouts largely shield the investor against extreme volatility. As a result, these stocks generally have low betas that are often below 1.0. By contrast, more speculative equities would be expected to have high betas.

Summary

Alpha and beta are fundamental terms in investing. Alpha measures the relative return, adjusted for risk, of an asset against a specific benchmark, such as the S&P 500. Beta measures the historic volatility of an asset against a benchmark.

As the S&P 500 is generally considered to be a proxy for the overall stock market, it has an alpha and a beta of 1.0. Therefore, a stock or mutual fund with a return greater than 1.0 would have achieved alpha, while a stock with beta below 1.0 would be less volatile than the overall market.