Why do alpha and beta matter in investments

Following this theory, a portfolio containing a variety of assets poses less risk and ultimately yields higher returns than one holding just a few. Algorithmic trading Buy and hold Contrarian investing Day trading Dollar cost averaging Efficient-market hypothesis Fundamental analysis Growth stock Market timing Modern portfolio theory Momentum investing Mosaic theory Pairs trade Post-modern portfolio theory Random walk hypothesis Sector rotation Style investing Swing trading Technical analysis Trend following Value averaging Value investing. Individual investors trying to replicate this strategy will find the latter scenario of producing tainted alpha to be the preferred method of execution. This translates to systematic risk that cannot be held at a steady value. The offers that appear in this table are from partnerships from which Investopedia receives compensation. The level of idiosyncratic risk individual security possesses is highly dependent on its own unique characteristics. Main article: Beta finance.

Q: I’ve seen the terms «alpha» and «beta» used frequently in the financial news. What do they mean?

In simple English, «alpha» refers to how well an investment performed relative to a certain benchmark index. Alpha tells you whether or not the investment outperformed positive alpha or underperformed negative alpha. On the other hand, «beta» gives you information about an investment’s volatility relative to the overall stock market. A beta of more or less than 1 indicates that the stock should be more or less reactive than the overall market. For instance, if your portfolio’s beta is 1.

Alpha is a measure of the active return on an investment , the performance of that investment compared with a suitable market index. Alpha, along with beta , is one of two key coefficients in the capital asset pricing model used in modern portfolio theory and is closely related to other important quantities such as standard deviation , R-squared and the Sharpe ratio. In modern financial markets, where index funds are widely available for purchase, alpha is commonly used to judge the performance of mutual funds and similar investments. As these funds include various fees normally expressed in percent terms, the fund has to maintain an alpha greater than its fees in order to provide positive gains compared with an index fund. Historically, the vast majority of traditional funds have had negative alphas, which has led to a flight of capital to index funds and non-traditional hedge funds. It is also possible to analyze a portfolio of investments and calculate a theoretical performance, most commonly using the capital asset pricing model CAPM.

We often hear the terms alpha and beta when talking about investments. Both of these indicators measure related, but different, things. Alpha, one of the most commonly quoted indicators of investment performance, is defined as the excess return on an investment relative to the return on a benchmark index. Alpha is also a measure of risk. In the above why do alpha and beta matter in investments, the means the aplha was far too risky given the return.

An alpha of zero befa that an investment has earned a return commensurate with the risk. Alpha of greater than zero means an investment outperformed. When hedge fund managers talk about high alpha, they’re usually saying that their managers are good enough to outperform the market.

But that raises another important question: when alpha is the «excess» return over an index, what index are you using? AAPL on Aug. So when judging whether a portfolio has a high alpha or not, it’s useful to ask just what the baseline portfolio is.

Unlike alpha, which measures relative return, beta is the measure of relative volatility. Beta is a multiplicative factor. Some investments with negative betas are inverse exchange-traded funds ETFs or some types of bonds. What beta also tells you is when risk cannot be diversified away. If you look at the beta of a typical mutual fundit’s essentially telling you how much risk you’re adding to a portfolio of funds. Morningstar, Inc. MORNfor example, uses U. Treasuries as its benchmark for beta calculations.

The firm takes the return of a fund over T-bills and compares that to the return over the markets as a whole and using those two numbers comes up with a beta. There are, though, a number of other benchmarks one could use. Alpha and beta are both risk ratios that investors use as a tool to calculate, compare, and predict returns.

They’re very important numbers to know, but one must check carefully to see how they are calculated. Risk Management. Investing Essentials. Tools for Fundamental Analysis. Mutual Funds. Mutual Fund Essentials. Financial Ratios. Your Money. Personal Finance. Your Practice. Popular Courses. Login Newsletters. Investopedia Trading. Key Takeaways Alpha is the excess return on an investment relative to the return on a benchmark index. Beta is the measure of relative volatility.

Alpha and beta are both risk ratios that calculate, compare, and predict returns. Compare Investment Accounts. The offers that appear in this table are from partnerships investemnts which Investopedia receives compensation. Related Articles. Mutual Funds What metrics do I use to evaluate the risk-return tradeoff for why do alpha and beta matter in investments mutual fund?

Mutual Fund Essentials 5 ways to measure mutual fund risk. Partner Links. Related Terms Risk Management in Finance In the financial world, risk management is the process of identification, analysis and acceptance or mitigation of uncertainty in investment decisions. Risk management occurs anytime an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment. Excess Returns Excess returns are returns achieved above and beyond whu return of a proxy.

Excess returns will depend on invdstments designated investment return comparison for analysis. The Information Ratio Helps Measure Portfolio Performance The information alhpa IR measures portfolio returns and indicates a portfolio manager’s ability to generate excess returns relative to a given benchmark.

What Are Risk Measures? Risk measures give investors an idea of the volatility of a fund relative to its benchmark index. Discover more about risk measures .

Investing Essentials. Risk Management. Tools for Fundamental Analysis. Beta is the measure of relative volatility. Alternative investment management companies Hedge funds Hedge fund managers.