If you feel the S&P 500 does not accurately represent the market as a whole, there are plenty of other indexes that you will find that may suit you better. There is a limitation, however, as many of the other indexes do not have the wide variety of investment options that the S&P 500 does. This usually limits individuals to using the S&P 500 index to obtain beta exposure.
Like any statistic, though, it should be used as a guide and not as a precision predictor of future price action. Statistically, beta is calculated by dividing the covariance of a stock’s return relative to the market by the variance in the market’s return. Both alpha and beta are backward-looking risk ratios and it is important to remember that past performance is no guarantee of future results.
- Alpha is the difference between the returns of a stock vs the expected returns based on its Beta.
- The performance of the stock market, whether as a whole or as different segments, is measured by stock market indexes.
- A 2X leveraged S&P 500 ETF has a beta very close to 2 relative to the S&P 500 by design.
- While alpha in stocks is a measure of performance and returns, beta is a measure of volatility vis-a-vis the market performance or index.
It’s crucial to realize that high or low beta frequently leads to market outperformance. A fund with lots of growth stocks and high beta will usually beat the market during a good year for stocks. Similarly, a conservative fund that holds bonds will have a low beta and typically outperform the S&P 500 during a poor year for the market.
Formula for Beta
As of Feb. 28, 2022, DGRW’s annualized return was 18.1%, which was also higher than the S&P 500 at 16.4%, so it had an alpha of 1.7% in comparison to the S&P 500. Beta is considered a measure of systemic vs. unsystemic risk in an asset. Low beta means that the asset has very little risk outside of those shared by all the other stocks on the market.
What is alpha?
Simply put, the alpha of a stock is a measure of the return on a stock investment as compared to a benchmark, such as an index. It essentially indicates the active return that is gained as a result of the stock’s performance after being adjusted for volatility and market fluctuations. A negative alpha in stocks means that a stock is underperforming the benchmark when adjusted for risk. If an investor is intending to match or outperform a specific benchmark and their investment portfolio is performing under that rate, then their alpha is negative. Alpha can also refer to the abnormal rate of return on a security or portfolio in excess of what would be predicted by an equilibrium model like CAPM. In this instance, a CAPM model might aim to estimate returns for investors at various points along an efficient frontier.
Applying Alpha to Investing
They’re very important numbers to know, but one must check carefully to see how they are calculated. For example, an 8% return on a mutual fund seems impressive when equity markets as a whole are returning 4%. But that same 8% return would be considered underwhelming if the broader market is earning 15%. But few experts would consider the S&P a proper comparison for Apple, given the differing levels of risk. The NASDAQ in that same yearlong period returned 15.51%, which pulls the alpha of that Apple investment down 2.63. So when judging whether a portfolio has a high alpha or not, it’s useful to ask just what the baseline portfolio is.
Alpha and Beta: What is the Difference for Investors?
It is important to understand that alpha does not tell you if an investment was profitable. If you have a specific symbol that you want to find Correlations for you can instead run the ‘Correlation, Alpha, Beta’ template and set the correlation symbol to your chosen symbol. The template will report the correlation, Alpha and Beta values of this symbol vs every symbol in your chosen list. If you have a list of stocks, one thing that you can do is compare the correlation of each stock in your list to every other stock in your list for a chosen time period.
Does Beta only capture downside price volatility?
An alpha of zero means that the investment was performed at the level of the market. Portfolio managers seek to generate a higher alpha by diversifying their portfolios to balance risk. An alpha of 1.0 means the investment outperformed its benchmark index by 1%. An alpha of -1.0 means the investment underperformed its benchmark index by 1%. For instance you can see that SPXS Direxion Daily S&P 500 Bear 3x ETF has nearly perfect negative correlation, -3x Beta (over longer time periods) and similar excess returns.
Gold, on the other hand, is quite volatile but has at times had a tendency to move inversely to the market. Lower beta stocks with less volatility do not carry as much risk, but generally provide less opportunity for a higher return. While alpha gives you an idea of how your investments have fared, beta is more concrete in calculating risk (especially through the CAPM). One common investment strategy using beta is to look for stocks that have high betas when the market is rising, and low betas if the market is falling. The reason being that high beta stocks, albeit riskier, have the potential to climb higher than the market. By contrast, lower beta stocks contain less risk than the market, and therefore shouldn’t sink lower than it.
A higher beta indicates a riskier investment with the potential of excess returns, while a lower beta indicates a more conservative investment with lower expected returns. Whether investors hope to increase their gains based on alpha https://1investing.in/ or beta investing, it’s important to work with an investment manager who has experience working with that specific risk, says Faber. Beta, on the other hand, measures how volatile an asset is compared to the overall market.
These two concepts are useful tools for every investor looking to make informed investment decisions. However, when evaluating potential investments, it’s best to consider both the alpha and beta, along with a host of other factors, and not just either/or. Remember that alpha and beta are both backward-looking data points, which cannot be used as evidence of future performance. In general, a higher alpha is more desirable for investors since it means greater return on investment. A lower alpha indicates the fund earned below the average expected for its risk level. For example, if a mutual fund returned 10% in a year in which the S&P 500 rose only 5%, that fund would have a higher alpha.
Beta, however, measures how volatile a specific investment is compared to an index. Many traditional index funds and ETFs are « capitalization-weighted. » This means that the individual stocks alpha and beta of stocks within the index are based on each stock’s total market capitalization. Stocks with higher market capitalizations are weighted more heavily than stocks with lower market capitalizations.
The performance of the stock market, whether as a whole or as different segments, is measured by stock market indexes. For example, the S&P 500 Index is a widely used measure of overall performance of the US stock market. As its name suggests, this index measures the daily changes among 500 large US corporations, based on their market capitalization. Individual investors trying to replicate this strategy will find the latter scenario of producing tainted alpha to be the preferred method of execution. This is due to the inability to invest in the professionally run, privately owned funds (casually called hedge funds) that specialize in pure alpha strategies.