You must have surely heard the mention of ‘alpha’ and ‘beta’ during your stock market research. You would have been even realizing that they are related to technical analysis of the market and are useful tools for the informed investor. But what do alpha and beta mean in a stock? Here’s what you need to know about these indicators as well as the key differences between them. So let discuss, Alpha/Beta in Stock Market.
To get a better understanding of the difference between alpha and beta, let us first understand what is alpha and beta in stock.
Looking at these concepts, you will be able to choose your investment portfolio in a better way.
What Is Alpha In The Stock Market?
Let us understand alpha in terms of stock investing.
Simply put, a stock’s alpha is a measure of the return on a stock investment compared to a benchmark, such as an index.
It essentially reveals the active returns obtained as a result of the stock’s performance after adjusting for volatility and market volatility.
The alpha of stock is represented by a single figure and can be either positive or negative depending on the performance of the stock.
The exact value of alpha represents the percentage by which the performance of the stock deviates from the benchmark.
Therefore, if a stock outperforms its benchmark price, its alpha is represented in the positive with a number that reveals the percentage by which it outperforms the market.
Meanwhile, a negative alpha reveals the percentage by which the stock underperforms.
The basic alpha calculation simply subtracts the total return on investment from the benchmark returns, over the same time period.
However, it is common practice to use the capital assets pricing model (CAPM), to get a more detailed view of a portfolio’s performance.
With this calculation, we subtract the risk-free rate of return (ROR) from the expected return, then we subtract the beta to obtain the risk premium.
This premium is then multiplied by the market return (reference value) minus the risk-free rate of return. The calculation looks like this:
Alpha = portfolio return — risk free MMR — beta * (benchmark return — risk free MMR)
Suppose the expected return is 12% after one year, the risk-free rate of return is 10%, the beta is 1.2, and the benchmark is 11%.
Your alpha calculation would then be 12–10–1.2 x (11–10).
This means that the alpha is 0.8%.
This positive percent shows your portfolio is faster performing than the market.
What Is Beta In The Stock Market?
Moving on to the discussion of alpha vs beta investing, let’s take a look at the concept of beta in relation to the stock market.
The beta coefficient, or as it is more commonly known — beta, is an indicator of a stock’s volatility or relative risk relative to the performance of the market as a whole.
This measure of volatility can provide an investor with important insight into whether the risk of a particular investment is higher or lower than the benchmark.
Like alpha, beta is also expressed in both negative and positive numerical figures.
This figure reveals whether the stock value is moving in the same direction and to the same degree as the benchmark.
The baseline is one, for the beta.
Any negative value shows the stock price is opposite to the market and a positive value shows that the price is according to that of the market.
It measures the expected changes in the stock relative to the movements in the market.
If the beta coefficient is greater than 1, it means that the stock is more volatile than the market.
If the beta is less than 1, it indicates that the stock has less volatility than the market.
It is a component of the CAPM that calculates the cost of equity funding.
While selecting stock, beta is of limited value.
Beta is a better indicator of short-term risk rather than long-term.
What Are The Differences Between Alpha & Beta Stocks?
As we review these two concepts and see what alpha and beta mean in the stock market, let us take a look at the differences between them.
The primary difference between alpha and beta stocks is the investment objective.
Although these are both technical analysis indicators, they are each used for different reasons.
Alpha reveals the degree of return of a stock with respect to a specific benchmark and therefore focuses more on the direct returns obtained through investments.
Beta, on the other hand, reveals the systematic risk or volatility associated with a stock.
When it comes to the question of what is alpha and beta in stocks, it is not a question of which of these two indicators is more useful.
Rather, it is more important that what are the needs of investor and how he is using beta and alpha to achieve his goals.
For example, if an investor accepts that the market is currently unfair and inefficient, he or she may go for higher-risk funds that they believe will provide higher alpha over time.
On the other hand, a more low-risk investor would choose to go with stock investments that offer lower beta values because they would provide less volatility than the market as a whole.
BottomLine:- With the help of this article I have tried to explain what are the alpha/beta in the stock market, what is alpha, and what is beta works. We have also explained the difference and advantages of both the indicators alpha and beta. I hope now you have a better understanding of both of these indicators.
Good Buy…
