Alpha vs. Beta In Investing: Definitions & Comparison (2024)

What Is Beta In Finance?

An investment's beta, or the beta coefficient, is statistical measure of the volatility of a certain investment's returns referenced against the market as a whole. The broad market is assessed to have a beta of 1.0. If an investment has a beta higher than 1.0, it is more volatile than the market and if an investment has a beta lower than 1.0, it is less volatile than the market.

Calculating Beta of an Investment

Beta can be calculated by dividing an investment's standard deviation of returns by a relative benchmark's standard deviation, then multiplying it by the correlation between the investment security and the benchmark.

Beta (β) = σ of investment / σ of benchmark

Tip: Beta is relatively easy to find on investment research websites, and is thus rarely necessary for investors to calculate its complex formula. For example, when researching a particular stock on Seeking Alpha, an investor can enter a stock's ticker and scroll down to the risk measures and see a stock's beta, as well as other risk measures, such as short interest.

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What Beta Tells Investors

Beta expresses how volatile an investment is compared to its benchmark index. Traditionally, the primary benchmark for stocks is the S&P 500 index, which is assigned a beta of 1.0. Growth stocks, and other stocks with high variability, generally have a beta above 1.0, which means they are expected to have wider price fluctuations (i.e. higher highs and lower lows) than the index.

The Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model, abbreviated as CAPM, was developed by William Sharpe, Jack Treynor, Jan Mossin, and John Lintner. The CAPM model creates a base estimate for a security's return based on the relation of beta to the market return.

CAPM Formula

Under CAPM, the expected return for a given asset is calculated as follows:

Expected Return = Risk-Free Return + {Beta X (Market Return - Risk Free Return))

CAPM Example

The Risk-Free rate of return generally uses U.S. Treasury yields by default. Consider the following inputs for calculating the expected return for XYZ stock.

• U.S. Treasury Rates = 4%
• Market Benchmark Return = 11%
• Beta of ABC stock = 1.4

In this example, the expected return for ABC stock would be:

= 4% + 1.4 x (11%-4%)

= 4% + 1.4 x (7%)

= 4% + 9.8%

= 13.8%

What is Alpha In Finance?

Alpha is a performance metric used to evaluate the returns of an investment security or a portfolio after adjusting for market-related volatility. Put simply, alpha expresses if the returns of an investment exceed the returns that its beta would predict.

Alpha is a performance ratio that is often used to evaluate an investment portfolio, along with the four main risk-related portfolio evaluation metrics, which are beta, standard deviation, R-squared, and Sharpe ratio.

Note: Proponents of the efficient markets hypothesis (EMH) generally disagree with the idea of achieving sustainable positive alpha because EMH states that consistently outperforming the market through stock selection and market timing is not possible.

What Alpha Tells Investors

Alpha tells investors how an investment performed relative to a benchmark, such as the , after adjusting for its risk, as measured by beta. For example, a positive alpha tells an investor that the performance of an investment or portfolio is in excess of what its market risk level would predict.

Calculating Alpha of an Investment

A basic way to determine alpha is by first calculating the expected return of an investment (or portfolio) using the CAPM formula, and then comparing the actual return to the expected return.

Alpha (α) = Actual Return - Expected return based on CAPM

Consider the following inputs:

• U.S. Treasury Rates = 4%
• Market Benchmark Return = 9%
• Beta of ABC stock = 1.3
• Actual return for ABC stock = 12%

Using the above inputs, the expected return for ABC stock would be:

= 4% + 1.3 x (9%-4%)

= 4% + 1.3 x (5%)

= 4% + 6.5%

= 10.5%

Since, in this example, ABC stock actually returned 12%, it earned an Alpha of +1.5%.

In practice, investments will earn positive alpha or negative alpha all the time. However, it's difficult for money managers to consistently produce positive alpha from their portfolios.

Differences Between Alpha and Beta

The differences between alpha and beta are primarily between what they measure, or what they tell investors.

• Alpha measures performance relative to an expected return.
• Beta measures the volatility of an investment returns relative to the market premium of benchmark index.
• The baseline measure for Alpha is zero, meaning that an investment's performance does not exceed its relative benchmark.
• The baseline measure for Beta is 1.0, where an investment's price movement (volatility) is the same as the benchmark index.

'Smart Beta'

Smart beta is an enhanced indexing investment strategy that utilizes some active management elements in combination with passive investing. The goal of smart beta investing is to achieve a positive alpha by outperforming a benchmark index ( or 'beating the market') while still maintaining the low relative beta of the index.

Bottom Line

Alpha is a measure of an investment's performance in relation to a benchmark and beta is a measure of price volatility compared to a benchmark. Both metrics can be used in assessing help investors assess investment returns.