Alpha And Beta Explained

Two terms often tossed around within the investing community are “alpha” and “beta.” While metrics such as price-to-earnings ratio and tangible book value per share are relatively self-explanatory, alpha and beta can seem very mysterious to new traders.

In reality, the two terms represent relatively straightforward ideas.

Beta

Beta is simply a measure of the relative volatility of a stock. Beta is calculated in relation to a benchmark, such as the S&P 500 for U.S. stocks. A beta of 1.0 means that a stock has historically demonstrated volatility in line with its benchmark. A beta greater than 1.0 suggests the stock is more volatile than the benchmark, and a beta less than 1.0 suggests the stock is less volatile than the benchmark.

For example, a U.S. stock with a beta of 1.5 has historically been 50 percent more volatile than the S&P 500.

Alpha

The mathematical formula for calculating alpha is the following:

Alpha = r - Rf - beta * (Rm – Rf)

Where:

r = the portfolio’s return

Rf = the risk-free rate of return

beta = the portfolio’s price volatility relative to its benchmark

Rm = the return of the benchmark

If the equation and variables above are generating nightmarish flashbacks to college math courses, don’t worry — the gist of alpha is much simpler than its calculation.

A positive alpha for a stock or portfolio means that it has outperformed its benchmark. For example, a portfolio of U.S. stocks with an alpha of 1.0 simply means that the portfolio has outperformed the S&P 500 by 1.0 percent. It’s that simple.

To Sum Up

All the average investor needs to know about beta is that it is a measure of relative volatility with 1.0 as its baseline. On the other hand, alpha is a measure of relative performance with 0.0 as its baseline.

A beta above 1.0 indicates more volatility than the overall market, and an alpha above 0.0 indicates better returns than the overall market.