Beta and Alpha Returns for Us Sane Investors

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.

First, Beta

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.

More on this topic (What's this?) Read more on Beta at Wikinvest

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{ 4 comments… read them below or add one }

George February 17, 2009 at 9:34 am

Beta is very important when analyzing stocks. It gives you a gauge of how volatile the stock can be without you adding subjective judgment. Great explanation!

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Frank Curmudgeon February 27, 2009 at 6:57 pm

Beta is the expected relationship between an individual stock’s return and the market return. I.e. it is the coefficient in the simple regression of stock return on market return. As you say, a stock with beta of 2 can be expected to return twice the market return, so if the market is up 10% you would expect the stock to be up 20%. However, stocks with betas less than one but larger than zero are not negatively correlated to the market as you have stated. A stock with a beta of 0.5 would be expected to return half the market return, so if the market is up 10% you would expect the stock to gain 5%.

Stocks with negative beta are inversely related to the market, so a stock with a beta of -1.0 would be expected to go in the opposite direction of the market but in the same magnitude. E.g. if the market is up 10% you would expect that stock to be down 10%. It is not clear that stocks with negative betas exist in the real world, other than such things as short funds.

Beta is indeed, as you say, a measure of risk. However, it is not a complete measure of risk, only a measure of one aspect of it. Stocks with high betas are by definition relatively volatile, because the market is volatile, but stocks with low betas are not, as you state, necessarily low risk. The classic example is a small biotech which could be very volatile but have a beta of zero, as it will go up or down based on the results of drug trials, etc.

Generally, the term alpha is used to refer to a manager’s stock picking value added, and is not used to describe a particular stock. Strictly speaking, it is the intercept of the regression mentioned above, not the error term, so even if applied to a single stock would not, as you say, represent everything that affects a stock returns other than beta.

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Doug March 11, 2010 at 11:31 pm

“When you see beta less than 1, it means that the stock goes down every time the market goes up. ”

Can I point out that this is just plain wrong? A beta of less than 1.0 does not mean an asset has a negatively correlation with the market. If an asset has a beta of less than 1.0 but greater than 0.0, it means the asset goes up when the market goes up but not as much as the market. It also means that the asset does not fall as much when the market declines.

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Ralph July 19, 2011 at 10:19 am

The following statement is wrong:

“If the stock moves exactly as the market does, the beta of it will be 0.”

Corrected, the statement should be:

“If the stock moves exactly as the market does, the beta of it will be 1″

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