Every investment involves two important aspects – returns and risk. And every investor wants to get the maximum returns with minimum risk. Alpha and beta parameters of the stock portfolio are used to describe the two main risks inherent in investing in stocks. Alpha relates to factors affecting the performance of an individual stock or the fund manager’s skill in selecting the stocks while beta relates to market risks.
Alpha is the risk-adjusted return on an investment. It is the return in excess of the compensation for the risk borne, and thus commonly used to measure the performance of fund manager in managing the fund portfolio. So usually an investor’s strategy should be to buy securities with positive alpha as these may be undervalued.
The alpha coefficient (αi) is a parameter in the capital asset pricing model (CAPM). It is the intercept of the security characteristic line (SCL), that is, the coefficient of the constant in a market modelregression.
It can be shown that in an efficient market, the expected value of the alpha coefficient is zero. Therefore the alpha coefficient indicates how an investment has performed after accounting for the risk it involved:
- αi < 0: the investment has earned too little for its risk (or, was too risky for the return)
- αi = 0: the investment has earned a return adequate for the risk taken
- αi > 0: the investment has a return in excess of the reward for the assumed risk
For instance, although a return of 20% may appear good, the investment can still have a negative alpha if it’s involved in an excessively risky position.
For efficient markets, the expected value of the alpha is zero. i.e α = 0 and the investment has earned a return adequate for the risk taken. Fund managers are rated according to how much alpha their fund generates. It is thus a measure of the fund manager’s ability to generate profits in excess of market returns. Fund managers are usually paid in accordance to how much alpha their fund generates. Higher the alpha, the higher is their fees.
Beta is a measure of a volatility of a stock and expresses the relation of movement of stock with the movement of market as a whole. The S & P 500 Index is assigned a Beta of 1. So a stock can have positive or negative value of beta.
If Beta = 1; that means security’s price will move in sync with the market.
If Beta is positive; that means stock moves more than the market and is more volatile.
If Beta is negative; that means stock moves less than the market and is less volatile.
High-beta stocks are generally riskier being more volatile but provide a potential for higher returns as these are in the early stages of growth. On other side low-beta stocks pose less risk and hence lower returns. Usually utilities stocks have a beta of less than 1 while high-tech stocks have a beta of greater than 1.
Having gone through the fundamentals of alpha and beta; it can be inferred that low beta and high alpha stocks are good. But blindly following this concept is not desirable because these parameters are calculated based on historical data and history is never the indicator of future performance of a stock portfolio.