Investors often use the metrics alpha and Beta when analyzing stocks and portfolios.
Let’s understand the benchmark index first. A benchmark index is a group of stocks an investor uses as a standard to compare their investments against. So, for example, when an investor says, ‘my portfolio is beating the market,’ what do they mean? The market is a benchmark index primarily represented by the Nifty 50, SENSEX, or other stock indexes. All of these include a defined number of stocks, and the increase and decrease of each of these indices are reported on the news each day as ‘the market went up or ‘the market dropped.’
What is Alpha?
The metric ‘Alpha’ is the movement of a stock or portfolio relative to a benchmark index. An Alpha of zero means that your stock or portfolio moves precisely the same as the benchmark index. If you use the Nifty 50 as your index and it closes the day up 2%, your stock or portfolio would also close up 2%.
Very few stocks and portfolios have an Alpha of zero; if they did, it would be no use to pick individual stocks to make your portfolio because you could buy a fund that matches your benchmark and get the same return. So, an alpha above zero represents how much better your stock or portfolio performed over time than the benchmark, while a negative alpha means your stock or portfolio is underperforming the index.
Considering all this, what does it mean if you have a portfolio of ten stocks over the last year, and your portfolio has had an alpha of 5%? It means your portfolio outperformed the index by 5%.
Does that mean you made money? Maybe. If the index increased 3% over the same time, your portfolio increased 8%. If, however, the index dropped 10%. However, your portfolio dropped by 5% only. You still lost money, but not as much value as the benchmark index.
A word of wisdom about using alpha as a metric to judge the value of your stock: Use a benchmark index representative of your stock and portfolio. For example, the Nifty 50 index includes the 50 largest companies on the National Stock Exchange.
Established companies’ stock prices are less volatile than a new tech companies. So using a broad-based index like Nifty 50 or SENSEX to calculate the alpha of your new tech company stock won’t tell you much about how your stock is doing. The relevant index could be Nifty IT.
Now let’s Understand, What is Beta?
While alpha compares the rate of return on a stock or portfolio to a benchmark, Beta measures the relative volatility of a stock; volatility is a term used to describe how much a stock moves up and down. For example, a Rs 200 stock with a range of Rs 175- Rs 225 on a specific day has more volatility than a Rs 100 stock with a range of Rs 45- Rs 60 on the same day.
Unlike alpha, which has a base value of zero, Beta has a base value of 1. This is because Beta is a multiplicative metric, meaning you multiply a stock’s Beta by the benchmark’s rate of return, and you get an expected rate of return for your stock. For example, if your benchmark index rises 5% over one month and your stock has a Beta of 1.5, you expect your stock to increase 4% (5%*1.5 = 7.5%). Hence, a beta of 1 results in the same rate of return (i.e. 5%* 1 = 5%).
Like Alpha, Beta can have a negative value. If the benchmark index increases, the stock tends to decrease, or vice versa. Also, Beta is calculated over time, so it is not a guarantee for future results. Each day, stocks are traded, and things happen a little differently, and those little differences can change a Stock’s Alpha and Beta. So while they are both suitable measures of how a stock behaves relative to a benchmark index, there is no guarantee it will react the same way every day.
Bottomline: Use Alpha and Beta to Gauge Investment Returns
Alpha is the difference between the rate of return of a stock or portfolio and a benchmark index. The base value of zero means that the stock or portfolio has the same rate of return as the benchmark index. A positive Alpha means the stock or portfolio outperforms the benchmark, while a negative Alpha means the stock or portfolio underperforms the index. Alpha is a differential value.
Like Alpha, Beta is a relative metric that compares the volatility of a stock or portfolio against a benchmark index. Volatility means how much the price of a stock or portfolio moves, so a high Beta means that the stock or portfolio is more unstable than the benchmark index. Beta can be a negative number; if it is, it just means that the stock moves in the opposite direction of the benchmark index. The base value for Beta is one.
Alpha and Beta allow investors to determine how their stocks and portfolios perform compared to ‘the market.’ If an investor cannot realize a positive Alpha, it would be better to invest in a fund that tracks the benchmark index.