Once you start analyzing stocks (usually after you lose money following “expert advice”), you will no doubt come across the terms beta and alpha. If you are wondering what they are, or are simply questioning why they are important to you as an investor, read on.
In the perfect world, stocks would go up because of strong fundamentals and go down when earnings deteriorate. In reality however, this is far from the truth. There is no doubt that fundamentals of the company play a huge role in its stock price, but psychology plays a big role in prices as well due to the inherit nature of any supply and demand marketplace. Sometimes, companies with strong and growing earnings are sometimes unjustifiably punished just because the whole market is going down. In order to measure this, Beta was created.
Beta is a mathematical term that measures how the stock moves relative to an index (e.g. S&P 500). The higher the beta, the more volatile it is against the index. For example, a stock that goes up 20% while the index goes up 10% will have a beta of 2, while a stock with beta 1.2 means that the stock will go up 20% more than the index. When you see beta less than 0, it means that the stock goes down every time the market goes up. If the stock moves exactly as the market does, the beta of it will be 0.
Therefore, stocks with low beta are ones that are less volatile and therefore carry less risk. A very aggressive stock (e.g. penny stocks for instances) could have a very high beta.
Then There’s Alpha
If beta is the measure of how prices relate to the overall market, alpha measures everything else that affect the price of the security. High alpha stocks tend to rise even when the whole market falls, and therefore it’s a very desirable attribute for a stock.
Basically, alpha is a measure of the buying pressure of the stock that is independent of the overall market forces. It doesn’t matter if it is related to the company’s strong fundamentals, or if it’s just a short covering rally.
What Beta and Alpha Mean for Us
These measures help us tremendously in building our portfolio. For example, by constructing a portfolio with a mixture of betas, we can further diversify risks in our portfolio.
The big caution about Beta and Alphas are the fact that they are backward looking (meaning they are based on historical data). Therefore, blindly following these numbers without thought is a cause for disaster.
Don’t just look at the numbers and assume low beta and high alpha is always good. Use them as another measurement to help your analysis.