Sometimes it may feel like your stock portfolio comes with a side of alphabet soup—particularly when you hear terms like alpha and beta thrown about. In fact, the concepts behind alpha and beta are simple.
Alpha describes how well your investment performs against a particular benchmark. For example, let’s say you own shares of a stock that had a return of 18% for a particular year. When you compare the performance of that stock to the S&P 500 index, which let’s say had a return of 10% for that year, your alpha is +8 because your stock performed 8 percentage points better than the S&P 500 benchmark. Similarly, if your stock had a return of only 7%, with the S&P 500 returning 10%, your alpha would be -3 because your stock performed 3 percentage points worse than the S&P 500.
Beta describes how volatile your investment is compared to the market. An investment that has a beta of exactly 1 will move with the market. Say you own shares of a stock that has a beta of 1, and the S&P 500 increases by 10%, you should expect your stock to increase by 10% as well. If your stock has a beta greater than 1, say 1.5, then you should expect the stock to move by 1.5% for every 1% change—and this applies to losses as well as gains. An investment that has a negative beta means it moves in the opposite direction of the market.
When it comes to professional investing, portfolio managers strive to add alpha and manage beta. Ultimately, investors care about alpha because it tells them how well their investment performed compared to the market, and they care about beta because it tells them how potentially volatile their investment is compared to the market.
Part of learning to be an investor is to get familiar with the terminology and demystify what may be confusing at first.
This information in the Financial Tips section is provided for educational purposes only and is not tax, legal, financial planning or investment advice. Neither the information nor any opinion expressed in this section constitutes an offer to buy or sell any securities or advisory products. The information provided is general and is not information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security. You should not regard this information as a substitute for the exercise of your own judgment. Investing involves risk.