With the quick advancement of technology, investing and the way to invest have become a lot easier today. While it is critical to invest in order to enhance one’s standard of living, it is equally critical to monitor the performance of one’s investments. Stocks and mutual funds, in particular, necessitate close monitoring. Investment choices such as stocks and mutual funds may have introduced investors to the words Alpha and Beta.
Alpha and Beta are two of the most critical performance measuring words in the financial world. The risk and return of a stock can be evaluated using Alpha and Beta.
What is Alpha?
The stock market’s success is measured in terms of alpha. It provides insight into the market performance of a certain stock. When the stock market rises, it has a beneficial effect on the value of individual stocks, which is known as Market Return. Some companies, on the other hand, outperform the market by providing larger returns. The difference between the stock returns and the benchmark (market) index is calculated using alpha.
A stock’s alpha tells investors how well it has done in the past. It’s possible for a stock’s alpha performance to be both favorable and negative. Positive values mean the stock outperformed, while negative values indicate that the stock underperformed, specifically.
Alpha (a) = Actual Return on a Stock – Expected Returns on a Stock
A score of 5, for example, indicates that the stock outperformed the market index by 5% and that the investor is “seeking positive alpha.”. The stock underperformed the market index by -1 percent if the result is -1.
It’s possible to learn about a stock’s previous performance in the stock market using alpha, but it’s impossible to predict how it will perform in the future.
What is Beta?
Stocks are widely recognized as a high-risk investment. Beta is a measure of a stock’s systematic risk or the risk that it is impossible to avoid. Beta is a measure of a stock’s volatility as compared to the whole market. A stock’s volatility might help investors evaluate if it’s worth their time and money.
Beta = Covariance / Variance
In the stock market, covariance describes the variation in performance between two similar stocks under various market situations. Positive covariance signifies two equities are moving in lockstep, whilst negative covariance indicates the polar opposite.
Variance is the difference between a stock’s price and its average, which indicates the stock’s price volatility.
A beta of 1 shows that the stock’s price is moving in the same direction as the market as a whole If the beta is greater than 1, the stock is more volatile than the market; on the other hand, if the beta is less than 1, the stock is less volatile. Beta is a measure of risk, and if the beta is high, the stock’s risk is high; if it is low, the stock’s risk is low. For the sake of this example, 1 is used as a benchmark for Beta in the stock market.
Usage of Alpha and Beta measurements
Alpha and Beta can be used as stock performance metrics by active investors in the stock market. Alpha can be used to estimate a stock’s performance, whereas Beta can be used to gauge the risk associated with a particular stock.
It is desirable that a stock with a high Alpha tends to be chosen by investors, but it is also mentioned that any stock that performs well at the current time may not do as well in the future. High Beta equities, on the other hand, will do well during market upswings and suffer catastrophic losses during market downturns. Low beta equities also do better in a bear market. High Alpha equities are preferred by active investors, whereas high beta companies are preferred by passive investors. Investors should keep in mind that the Alpha and Beta decisions are up to each individual.