What is one of the most important aspects you need to check when you are evaluating a stock, any other market-linked asset or even a portfolio? The first item on the long list of answers is the performance of the asset or asset basket. Alpha and beta are tools that help you evaluate this performance. By checking the alpha and beta before you make an investment or during your periodic portfolio review, you can obtain clarity on which assets align with your financial goals and which ones are unsuitable for you.
To make the most of these analytical tools, you must first understand what alpha and beta are and how they are calculated and interpreted.
What are alpha and beta in the share market
The alpha and beta are among the five technical investment risk ratios discussed in Modern Portfolio Theory (MPT). They can be calculated for any individual asset like a stock or security that is linked to the broad market. Furthermore, you can also compute the alpha and beta for a portfolio of market-linked securities.
The data used to calculate the alpha and beta are historical, so you can only find these metrics to assess the past performance of an asset or asset basket. While past performance is not a guarantee of future returns, knowing the historical alpha and beta of any stock or portfolio helps you assess how well that asset or asset group aligns with your risk-reward expectations.
Alpha: An overview
The alpha (denoted using the Greek letter α) measures the returns from a stock, security or asset in comparison with its benchmark. In its simplest version, the alpha essentially tells you the excess returns generated by an asset over and above its benchmark. For instance, if a fund has delivered returns of 12% but its benchmark has only yielded returns at 9% during the same period, the alpha of the fund is the difference of 3%.
However, this kind of simple calculation is unrealistic because it does not factor in the risk. For that, we have Jensen’s alpha.
Calculating Jensen’s alpha
Jensen’s alpha is a variation of the alpha of a stock, security or asset basket. It takes into account the risk that market-linked investments carry. To calculate Jensen’s alpha for any market-linked asset, you can use the following formula:
| Jensen’s Alpha = r – Rf – Beta x (Rm – Rf) |
Where:
‘r’ is the actual return from the asset or portfolio
‘Rf‘ is the risk-free rate of return (typically the rate offered by Treasury Bills)
Beta is the systematic risk of the asset or portfolio
‘Rm’ is the return from the market or the benchmark
Let us discuss an example to understand this better. Consider the following metrics for a hypothetical mutual fund scheme.
- Actual returns from the fund = 16%
- Benchmark index yield during this period = 10%
- Risk-free rate of returns = 7%
- Fund beta = 1.2
In this case, the standard alpha will be the excess returns delivered by the fund, which is 6% (i.e. 16% — 10%). However, Jensen’s alpha will be computed as follows:
Jensen’s alpha:
= r – Rf – Beta times (Rm – Rf)
= 16% — 7% — 1.2 (10% — 7%)
= 9% — 1.2 times (3%)
= 5.4%
Interpreting the alpha of a stock or portfolio
The alpha of a stock or portfolio is expressed as a percentage or an absolute value. Either way, it tells you how much the returns of the stock exceeded or fell short of its benchmark returns.
For instance, an alpha of 4% means that the stock or fund performed better than its benchmark by 4%. An alpha of —2% means the stock’s returns were less than the benchmark’s by 2%.
Beta: An overview
The beta of a stock or portfolio tells you about its systematic risk — which is the risk that can be traced back to the broad market. In other words, it tells you how volatile an asset is when compared with the broad market. The beta is important because it helps you assess if an investment is too risky for your portfolio.
Calculating beta
To compute the beta of a stock, security or any portfolio, the formula shown below can help.
| The beta of a stock or fund = (Covariance of the asset’s returns with the market’s or index’s return) ÷ Variance of the market/index return |
Interpreting the beta of a stock or portfolio
The beta of any asset is fairly easy to interpret. For instance, if the beta of a mutual fund scheme is 1.7, it is 70% more volatile than the index or broad market that you are comparing the fund with. The general scale for interpreting the beta of an asset is as follows:
| Beta Value | Interpretation |
| An absolute value of more than 1.0 | The stock or portfolio is more volatile than the index or broad market |
| An absolute value of 1.0 | The stock or portfolio moves to the same extent as the index or broad market |
| An absolute value less than 1.0 | The stock or portfolio is less volatile than the index or broad market |
| 0.0 | The volatility of the stock or portfolio cannot be correlated with the index or broad market |
| Negative beta | The stock moves in the direction opposite to the index or broad market |
Alpha vs. beta: The main differences
To make the most of risk ratios like alpha and beta in the stock market, you need to understand not only what they mean but also how they are different. The table below summarises the key differences between alpha and beta.
| Particulars | Alpha | Beta |
| What it measures | The excess return of an investment relative to the return of a benchmark index | The volatility of an investment relative to the broad market |
| Purpose | Used to assess the returns of an investment | Used to understand the risk of an investment |
| Interpretation | A positive value indicates outperformance, while a negative value indicates underperformance | A beta over 1 indicates higher volatility, while a beta lower than 1 indicates less volatility |
| Investment decision | Investors look for positive alpha to choose investments that outperform the market | Investors expect the beta to match their risk tolerance and market expectations |
Conclusion
In evaluating stocks or portfolios, understanding alpha and beta is crucial. Alpha measures excess returns compared to a benchmark, while beta assesses volatility relative to the market. Jensen’s alpha incorporates risk. Positive alpha signifies outperformance, while beta indicates risk tolerance alignment. These metrics aid investors in making informed decisions aligned with financial goals and market expectations.
