Alpha & Beta

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.
 What Does Beta Mean?
• 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.
 What Does Beta Mean?
• 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.
• We 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.
 What Does Alpha Mean?

1. An alpha of zero means the investment has

exactly earned a return adequate for the
volatility assumed.
2. An alpha over zero means the investment has
earned a return that has more than
compensated for the volatility risk taken.
3. An alpha of less than zero means the
investment has earned a return that has not
compensated for the volatility risk assumed.
 Alpha contd.
• 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.
 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?
 Stock Beta and Alpha as an Example
• 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.