Almost every investor hopes to make returns on their investment and with every investment, there is an element of risk. It is therefore a known fact that investors want to get as much return as possible with the least amount of risk. There are many variables with which to measure the return of an investment relative to its risks, we will limit this blog to Alpha and Beta, as a means of choosing stocks.
Alpha is the risk-adjusted return on an investment. It is excess return of a stock portfolio over a given benchmark. Alpha yields itself easily as a measure the performance of a stock relative to the performance of a bench mark. When an investment outperforms its benchmark, meaning that the investment generated more reward for a given amount of risk over the benchmark within the measurement period, its alpha becomes positive. On the other hand, if an investment underperforms the benchmark, meaning that the investment earns too little for its risk, its alpha is said to be negative. In efficient markets, which rarely is the case, alpha is expected to be zero, in which case an investment has earned a reward that is commensurate with its risk.
Often times, stock market commentators or analysts talk about the volatility of the market. In most cases, this volatility is measured with Beta which is an expression of the movement in the price of a stock relative to the movement of the market as a whole. The market, like the NSE Allshare index is assigned a Beta of 1, such that a stock can have beta value of greater than or less than 1 depending on its movements in relation to the NSE Allshare index. A stock that has a beta of 1 means that it moves in sync with the NSE ASI while one with a beta value greater than 1 is more volatile than the market (ASI) and a stock with a beta value of less than 1, is said to be less volatile than the market. Specifically, a stock with beta 1.3 means that the stock will go up 30% more than the index while a stock with beta less than 0, means that the stock goes down every time the market goes up
High-beta stocks are generally riskier and more volatile but they provide a potential for higher returns. On the other hand, low-beta stocks pose less risk and hence provide lower returns.
What is in it for you
Knowing the Alpha and Beta of stocks is very helpful to an investor in that it helps in building investment portfolio. When a portfolio is made up of assets with mixed beta, such portfolio becomes diversified in terms of risk. Beta can be used to create a balanced portfolio and reduce volatility.
In summary, one could say that low beta and high alpha stocks are good. However, it is good to note that the concept should be taken within limits of an investors risk appetite and risk tolerance. It is also noteworthy to point out that Alpha and Beta are calculated based on historical data and history is not an indicator of future performance of a stock portfolio. Alpha and Beta are also time dependent in their calculation in that a calculation based on a 5-year data may differ from one based on a 3-year data.
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