How to use these measures to strike a balance between investment risk and return
If you’ve been trying to be in the know about the stock market, you’ve probably come across the terms “alpha” and “beta”. These Greek terms are both used to determine an investment’s risk-reward (or profit-loss) profile. Rest assured, there are no pledges or toga parties here, but these two terms do dictate the moves investors make. And although each has its own unique characteristics, they often intermingle. Here’s what you need to know about these ‘sorority sisters’ of stock market risk.
Alpha: It’s all about fitting in
Went it comes to alpha, fitting in is key. Alpha tells investors which stocks meet or exceed the status quo and, ultimately, which are worth investing in.
In the investing world, alpha tells it like it is about a stock’s performance compared to its benchmark, such as the S&P 500 or the Dow Jones Industrial Average (DJIA). More specifically, it measures the excess return an investment produces compared to how much risk it presents to the investor. A positive alpha of 1.0 means the fund or stock has outperformed its benchmark index 1 percent. A similar negative alpha of 1.0 would indicate an underperformance of 1 percent. An alpha of zero means an investment fits right in with the index in terms of the amount of risk required to get its return.
Why should you care? Because if you can get the same returns in an index fund as you are in your higher-risk stock portfolio, go for the index fund. In this example, you could be getting similar returns for less risk (and probably much lower fees).
Beta: Do you have a wild side?
Think of a high-beta stock as a blind date; it’s exciting, but if you don’t get Prince Charming, you’re likely to end up with a frog.
Beta focuses on how much an investment moves compared to the market as a whole, and helps investors determine which investments are a good fit for their risk tolerance. Young, risk-loving investors with a wild side may be more comfortable with high-beta stocks. These carry higher risk, but also a higher expected return. Older investors who’ve left their wild-child days behind them may be better suited to low-beta stocks; no thrilling highs or crushing lows here – just steady, dependable income.
How does beta work? A beta of one suggests that you have an investment that will move in lock-step with the market, whether it jumps or gets low. If, on the other hand, you have a stock with a beta of 1.5, it will be more volatile than the market as a whole or make bigger moves. When the market moves up, this stock will move 50 percent higher. When it declines, it will (at least theoretically) dive 50 percent lower. On the opposite end, if you have a stock with a beta of 0.5, it will only rise half as much as the market. The benefit is that it will only fall half as much too.
The alpha/beta mixer
Investors can use both alpha and beta to judge a manager's - or individual stock's - performance. But when it comes to actually choosing a stock, it’s all about personal taste. Most investors welcome a high alpha and a low beta. Still, other investors might like the higher beta, especially if they’re looking to cash in on short-term market moves.
Indeed, the thrill of high returns is always tempting for investors, but this is one party that might be shut down early - before many investors even get a chance to enjoy themselves. That’s why alpha and beta are so important. Higher risk means the potential for higher rewards, but that doesn’t mean a high-risk stock guarantees a good time – you might just wake up to the worst hangover of your life. Alpha and beta thus help investors weigh potential risk against the likelihood of a big payoff.
In the end, it’s all about balance. Alpha and beta can help you strike that investment balance that ensures reasonable returns and a good night’s sleep – no keg stands or all-nighters required.