What is the difference between alpha and beta? This question often arises in the context of financial analysis, where investors and analysts use these terms to evaluate the performance of stocks and investment portfolios. While both alpha and beta are measures of risk and return, they serve different purposes and are calculated in distinct ways.
Alpha, also known as the Jensen’s alpha, is a measure of the excess return of an investment compared to a benchmark index. It indicates the skill of a portfolio manager in generating returns above the expected return, given the level of risk. A positive alpha suggests that the investment has outperformed the benchmark, while a negative alpha indicates underperformance. The formula for alpha is:
Alpha = (Actual Return – Expected Return) – Beta (Market Return – Expected Market Return)
On the other hand, beta is a measure of the volatility or systematic risk of an investment relative to the market. It measures how much the investment’s returns move in relation to the overall market. A beta of 1 implies that the investment’s returns move in line with the market, while a beta greater than 1 indicates higher volatility and a beta less than 1 suggests lower volatility. Beta is calculated using the following formula:
Beta = Covariance (Investment Returns, Market Returns) / Variance (Market Returns)
In summary, alpha focuses on the excess return generated by an investment, reflecting the skill of the portfolio manager, while beta measures the volatility of the investment relative to the market. Both metrics are essential for understanding the risk and return characteristics of an investment, but they serve different purposes in the evaluation process.
