You may have certainly heard mentions of ‘alpha’ and ‘beta’ during the course of your stock market research. You may even have an inkling that they pertain to technical analysis of the market and are useful tools for the informed investor. But exactly what does alpha and beta mean in stocks? Here’s what you need to know about these indicators as well as the crucial differences between them.
What is Alpha in the Stock Market?
In order to get a better picture of the differences between the two, let us first understand what is Alpha and Beta in stocks. Reviewing both of these concepts are certain to add value to your stock investment decisions and will help clarify the specific distinction with respect to alpha vs beta stocks.
Let us start off with understanding Alpha in terms of stock investment. Simply put, the alpha of a stock is a measure of the return on a stock investment as compared to a benchmark, such as an index. It essentially indicates the active return that is gained as a result of the stock’s performance after being adjusted for volatility and market fluctuations.
The alpha measure in stocks is represented by a single figure and can be either positive or negative, depending on the stock’s performance. The exact value of the alpha represents the percentage by which the stock’s performance deviated from the benchmark. So, if the stock performs better than its benchmark value, its alpha is represented in the positive with a number that indicates the percentage by which it outperformed the market. Meanwhile, a negative alpha indicates the percentage by which the stock underperformed.
Alpha and other ratios
Along with alpha, other ratios are used to judge performance of stocks. One of them, which is used in conjunction, is called beta. While alpha in stocks is a measure of performance and returns, beta is a measure of volatility vis-a-vis the market performance or index.
Other ratios such as the Sharpe ratio, standard deviation and R-squared are frequently used along with alpha and beta to weigh the performance of a stock or a fund.
Jensen’s alpha and CAPM
A more in-depth analysis and understanding of alpha would lead a stock market investor to the term Jensen’s alpha. So, what is Jensen’s alpha? This is a term used when the model of capital asset pricing comes into play. This model, abbreviated as CAPM, uses beta as well to compute the returns expected based on the asset’s beta and expected benchmark/market returns. In this model, both alpha and beta values are used to calculate returns. CAPM aims to forecast returns from an investment on the basis of level of risk, the market returns and the particular investments that have been chosen.
In fact, it was Michael Jensen who was instrumental in creating the alpha index, which is now known as Jensen’s alpha.
If you are using only alpha in stocks, you should consider certain factors before using the value:
Now that you know what is alpha in stock market, you are aware that any basic alpha calculation involves deducting the return on an investment from returns from a benchmark that is comparable. However, it is important to take note that this value works best when you are comparing the performance of similar assets. So, if you want to compare performance of one kind of asset with another, the alpha values you may come up with may not be reliable.
Also, there is the risk of using a wrong benchmark which can change alpha values and mislead an investor. Take, for example, a small cap stock. Small caps typically have higher returns than large caps. So, if you were to use a benchmark of large caps while assessing a portfolio of small caps, the alpha may be higher because you may not have taken into account the fact that the returns are because of the small cap market movements.
Alpha and efficient market hypothesis
The efficient market hypothesis or EHM says that all the information pertaining to stocks or investments are already accounted for in the price of an asset. In other words, an asset’s price reflects every possible and available information at any given time. If one were to go by this hypothesis, every security is priced correctly and appropriately at any point in time, so identifying and taking advantage of mispricing is absent. However, markets in reality don’t always behave as per the hypothesis, and there are stocks and portfolios that show alpha.
The answer to the question on “what is alpha in stock market investments” is that it is a technical analysis ratio that tells you how a stock has performed or yielded results in comparison with a benchmark or a market index. The alpha percentage, often represented in plain numbers such as alpha of 4 or 5, or an alpha of -1, is the value by which a stock or portfolio has outperformed or underperformed vis-a-vis the benchmark. A high alpha means a strong stock and a negative alpha could indicate a weak stock.
What is Beta in the Stock Market?
Moving on in the discussion of alpha vs beta investing, let us take a look at the concept of beta as it relates to the stock market.
Beta coefficient, or as it is more commonly known – beta, is an indicator of the volatility or relative risk of a stock as compared to the entire market’s performance. This measure of volatility can offer crucial insight to an investor about whether the risk of investing in particular is higher or lower than the benchmark.
Like alpha, beta is also expressed in simple numerical figures, both positive and negative. It also resembles alpha in that it actually represents a percentage to show how much more volatile that stock is as compared to the market. The figure indicates whether or not the stock value is moving in the same direction and to the same degree as the benchmark. The baseline for beta is one, and any positive value would indicate that the stock price is moving as per market movements while negative values indicate the opposite.
What are the Differences Between Alpha and Beta Stocks?
As we review these two concepts and discover what is alpha and beta in the stock market, let us take a look at the differences between them.
The primary difference in alpha vs beta stocks investing is that of purpose. While both of them are technical analysis indicators, each of them is used for different reasons. Alpha indicates the degree of a stock’s return with respect to a specific benchmark and is hence more focused on the direct rewards gained through investment. On the other hand, beta indicates the systematic risk or volatility associated with a stock.
When it comes to the question of what is alpha and beta in stocks, it is not a question of which of these two indicators is more useful. Rather, it is more a matter of what the requirements of the investor are and how he plans on using alpha vs beta investing to achieve his investment goals.
For instance, if an investor recognises that there is mispricing and inefficiency currently in the market, he can go for high-risk funds that he believes would offer high alpha over time. On the other hand, a more low-risk investor would choose to go with a stock investment that offers low beta values since they would offer less volatility than the market as a whole.
Conclusion
For the research-oriented investor, knowing what is alpha and beta in the stock market can prove to be a favourable tool on his side. Alpha vs beta investing can not only help you make the right investments in the stock market, but can also be useful indicators for entering and exiting the market. As is the case with all forms of market-oriented technical analysis, it is crucial to do your fair share of research before relying on these indicators for your investments.
