Alpha and Beta: How Do They Relate to Investment Risk?
Alpha and beta are two common measurements of investment risk. However, I must add a caveat before we jump in. Alpha and beta are part of modern portfolio theory, much of which is questioned by analysts (including myself). That doesn’t mean you can’t use the concepts of alpha and beta to have a better understanding of investing.
First we will examine Alpha and beta. Then we will look at how a value oriented investor can approach these two investment concepts and become a better investor.
Difference Between Alpha and Beta
Beta is a historical measure of volatility. Beta measures how an asset (i.e. a stock, an ETF, or portfolio) moves versus a benchmark (i.e. an index).
Alpha is a historical measure of an asset’s return on investment compared to the risk adjusted expected return.
What Does Beta Mean?
A beta of 1.0 implies a positive correlation (correlation measures direction, not volatility) where the asset moves in the same direction and the same percentage as the benchmark. A beta of -1 implies a negative correlation where the asset moves in the opposite direction but equal in volatility to the benchmark.
A beta of zero implies no correlation between the assets. Any beta above zero would imply a positive correlation with volatility expressed by how much over zero the number is. Any beta below zero would imply a negative correlation with volatility expressed by how much under zero the number is. For example a beta of 2.0 or -2.0 would imply volatility twice the benchmark. A beta of 0.5 or -0.5 implies volatility one-half the benchmark. I use the word “implies” because beta is based on historical data and we all know historical data does not guarantee future returns.
What Does Alpha Mean?
Alpha is used to measure performance on a risk adjusted basis. The goal is to know if an investor is being compensated for the volatility risk taken. The return on investment might be better than a benchmark but still not compensate for the assumption of the volatility risk.
An alpha of zero means the investment has exactly earned a return adequate for the volatility assumed. An alpha over zero means the investment has earned a return that has more than compensated for the volatility risk taken. An alpha of less than zero means the investment has earned a return that has not compensated for the volatility risk assumed.
By risk adjusted we mean an investment return should compensate for beta (volatility). According to Modern Portfolio Theory if an investment is twice as volatile as the benchmark an investor should receive twice the return for assuming the additional volatility risk. If an investment is less volatile than the benchmark an investor could receive less return than the benchmark and still be fairly compensated for the amount of volatility risk taken.
Interested in Quantitative Analysis?
Stock Beta and Alpha as an Example
Let’s assume company XYZ’s stock has a return on investment of 12% for the year and a beta of + 1.5. Our benchmark is the S&P500 which was up 10% during the period. Is this a good investment?
A beta of 1.5 implies volatility 50% greater than the benchmark; therefore the stock should have had a return of 15% to compensate for the additional volatility risk taken by owning a higher volatility investment. The stock only had a return of 12%; three percent lower than the rate of return needed to compensate for the additional risk. The Alpha for this stock was -3 and tells us it was not a good investment even though the return was higher than the benchmark.
The Correct Approach for the Value Oriented Investor
Volatility can be a blessing or a curse. That depends on how you, the investor, react to it. If you buy when everyone else is (the price is high) and sell in a panic when everyone else is selling (the price is low) then volatility is a curse. We are all prone to emotional bias.
However if you anticipate volatility it can be a blessing. The key is to stay focused on buying investments with a margin of safety. That means being disciplined in your approach to buying and selling. If you require a margin of safety it forces you to buy at a low price and sell when the price exceeds its value.
The slogan for the Dividend Value Builder is: “Discover, Evaluate, and Compare Dividend Stocks Without Emotional Bias.” The key is “without emotional bias”. Learning how to employ a margin of safety into your investment analysis helps you eliminate the emotional bias that causes us to make catastrophic errors.
If you buy a high beta stock for more that it’s worth the risk of losing your principal is very high (even greater than if you buy a low beta stock). The time to buy any asset, but especially a high beta stock, is when the price is well below its real value. Your risk is lower and your probability of a positive return is exponentially higher.
Whether you are buying high beta stocks or dividend stocks; being patient and only buying investments whose price is less than the real value of the asset lowers your risk substantially. Real risk is losing your principal. If you have an investment that is worth $100 but only pay $75 you have a 33% ($25 / $75) margin of safety.
I trust this discussion of alpha and beta has improved your understanding of what is takes to be a more successful investor. The most important thing you can do is develop a risk management plan. Positive alpha can be achieved with proper asset allocation, diversification, choosing individual investments with strategic advantages, and most importantly employing valuation strategies including requiring a margin of safety.
Related Reading: Perceived Risk vs. Real Risk: A Key to Successful Value Investing
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