What is Alpha and Beta in Stock Market?

Embarking on the journey of stock market investing can be thrilling, but with countless factors to consider, it can also be overwhelming. In the world of investments, two seemingly mysterious characters play pivotal roles in shaping your financial success—Alpha and Beta. 

By understanding these essential metrics and learning how to harness their power, you can unlock the doors to a prosperous portfolio.

In this blog, we’ll unravel Alpha and Beta, demystify their roles in the stock market, and provide you with insights to make informed investment decisions.

What is Alpha in the Stock Market?

Alpha quantifies the excess investment returns after accounting for market fluctuations and random variations. It evaluates an investment’s performance in comparison to a benchmark index like NIFTY 50 or SENSEX.

How to Calculate Alpha of a Stock?

Alpha, represented by the symbol ‘α,’ is calculated as:

Alpha (α) = Current Return Rate – Expected Return Rate

A higher Alpha value is means you have outperformed the benchmark index by a higher

For example, let’s assume the following return rates:

Current Return Rate: 8%

Expected Return Rate: 6%

Using the formula given, we can calculate alpha as:

Alpha (α) = Current Return Rate – Expected Return Rate

Alpha (α) = 8% – 6%

Alpha (α) = 2%

In this example, the portfolio’s alpha is 2%, indicating that it has outperformed its expected return rate by 2%.

What is Beta in the Stock Market?

Beta sometimes called the Beta coefficient, signifies systematic risk or potential hazards that cannot be prevented. It evaluates the volatility of a stock, investment, or portfolio within the market. Using historical data, it determines the correlation between an investment’s movement and market fluctuations.

The Beta coefficient measures an asset’s riskiness. A Beta value of one indicates that the investment’s price moves with the market. A Beta value above 1 suggests that the investment is more volatile than the market, while a Beta value below 1 indicates that the investment is less volatile than the market or index.

How to Calculate the Beta of a Stock?

Beta, represented by the symbol ‘β,’ is calculated as:

Beta (β) = Covariance/Variance

Let’s understand this with an example. Suppose we want to calculate the beta of a stock, ABC, relative to the Nifty 50 index. Let’s assume that over a given period, the Nifty 50 index has had an average return of 12% with a standard deviation of 8%, while ABC stock has had an average return of 14% with a standard deviation of 10%.

To calculate the beta of ABC stock, we need to calculate the covariance between the stock and the market, as well as the variance of the market:

Covariance: This measures how much the returns of ABC stock and the Nifty 50 index move together. Let’s say that over the same period, the covariance between ABC stock and the Nifty 50 index is 0.05.

Variance: This measures how much the overall stock market return varies from its mean. The variance can be calculated as the square of the standard deviation:
Let us assume NIFTY 50 has an 8% standard deviation,
So,
Variance = 8% x 8% = 0.0064.

Therefore Beta according to the formula will become,

Beta (β) = 0.05 / 0.0064

Beta (β) = 7.81

In this example, the beta of ABC stock is 7.81, indicating that the stock is more volatile and risky than the Nifty 50 index (which has a beta of 1 by definition). Therefore, ABC stock would be considered a high beta stock and may be favoured by investors with a high-risk tolerance.

Comparison of Alpha and Beta Stock Market Values

Alpha value compares an investment’s total return to a benchmark index’s gross return. Conversely, Beta assesses the volatility of an asset relative to a benchmark index. When evaluating mutual funds, the Alpha value is often used. 

If you understand how a specific mutual fund has performed historically compared to a benchmark index, you can use the Alpha value to determine whether the fund has outperformed or underperformed.

Alpha is calculated by taking the specific fund’s investment return and subtracting it from the corresponding index’s investment return. A high Alpha value implies that the specific fund has outperformed the benchmark index in the past, while a negative or low Alpha indicates that the fund has underperformed the index. An Alpha value of zero means that the fund has previously generated the same expected return as the benchmark index.

In contrast, the Beta value is designed to evaluate an investment’s riskiness or volatility compared to a benchmark index.

A Beta value of 1.0 signifies that the investment is as volatile as the benchmark index. If the Beta value is 1.3, the investment is 30% more volatile than the benchmark. If the Beta is 0.7, it means the stock is 70% less volatile than the index.

The table below presents a comparison between Alpha and Beta values, highlighting their distinct characteristics:

What is the best option for you?

Suppose you’re considering investing in mutual funds and want to select a fund from a list that has consistently outperformed the broader stock market. In that case, you should examine the mutual fund’s Alpha value to gauge its recent performance and compare it with the Alpha value of a benchmark index before making the optimal choice.

You can use the Alpha value of a stock to:

• Compare the profitability of mutual funds with a baseline index
• Identify the most suitable mutual fund for your financial objectives
• Evaluate and rank different investment opportunities

If you prefer to avoid risky investments, you can use the Beta value to help you pinpoint assets that fall within your desired risk threshold. Additionally, you can use the Beta value of a stock to:

• Compare an investment’s volatility with a baseline index
• Align your assets with your overall risk profile

Conclusion

An important observation is that both Alpha and Beta investing rely on historical data and do not guarantee future performance of the fund. While understanding the past is crucial, it’s essential to evaluate its prospects before making an investment!

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