Alpha and beta for beginners

We often hear the terms alpha and beta when talking about investments. Both of these indicators measure related but different things.

Alpha, one of the most commonly quoted indicators of investment performance, is defined as the excess return on an investment relative to the return on a benchmark index. For example, if you invest in a stock and it returns 20% while the S&P 500 earned 5%, the alpha is 15. An alpha of -15 would indicate that the investment underperformed by 20%. Alpha is also a measure of risk. In the above example, the -15 means the investment was far too risky given the return. An alpha of zero suggests that an investment has earned a return commensurate with the risk. Alpha of greater than zero means an investment outperformed. (For more, see "Bettering Your Portfolio With Alpha and Beta.") 

Alpha is one of the five major risk management indicators for mutual funds, stocks and bonds, and in a sense tells investors whether an asset has performed better or worse than its beta predicts.

When hedge fund managers talk about high alpha, they're usually saying that their managers are good enough to outperform the market. But that raises another important question: when alpha is the "excess" return over an index, what index are you using? For example, a fund manager might say that she or he generated a 20% return when the S&P returned 15%, an alpha of 5. But is the S&P an appropriate index to use? Consider a manager who has invested in Apple Inc. (AAPL) on Aug. 1, 2014. Compared to the S&P 500, the alpha would look quite good: Apple returned 18.14%, while the S&P 500 returned 6.13%, for an alpha of about 12.

But few experts would consider the S&P a proper comparison for Apple, given the differing levels of risk. Perhaps the NASDAQ would be a more appropriate measure. The NASDAQ in that same yearlong period returned 15.51%, which pulls the alpha of that Apple investment down 2.63. So when judging whether a portfolio has a high alpha or not, it's useful to ask just what the baseline portfolio is. (For more, see "Adding Alpha Without Adding Risk.")

Unlike alpha, which measures relative return, beta is the measure of relative volatility. It measures the systematic risk of a security or a portfolio in comparison to the market as a whole. A tech stock such as that mentioned in the example above would have a beta in excess of 1 (and probably rather high), while a T-bill would be close to zero, because its prices hardly move relative to the market as a whole.

Beta is a multiplicative factor. A stock with a beta of 2 relative to the S&P 500 goes up or down twice as much as the index in a given period of time. If the beta is -2, then the stock moves in the opposite direction of the index by a factor of two. Some investments with negative betas are inverse exchange-traded funds (ETFs) or some types of bonds. (For more, see "Beta: Know the Risk.")

What beta also tells you is the risk that cannot be diversified away. If you look at the beta of a typical mutual fund, it's essentially telling you how much risk you're adding to a portfolio of funds.

Again, similar caveats to alpha apply: it's important to know what you're using as your benchmark for volatility. Morningstar, Inc. (MORN), for example, uses U.S. Treasuries as its benchmark for beta calculations. The firm takes the return of a fund over T-bills and compares that to the return over the markets as a whole and using those two numbers comes up with a beta. There are, though, a number of other benchmarks one could use. (For more, see "Beta: Gauging Price Fluctuations.")

Alpha and beta are both risk ratios that investors use as a tool to calculate, compare, and predict returns. They're very important numbers to know, but one must check carefully to see how they are calculated. (For more, see "A Deeper Look at Alpha.")