Balancing Alpha And Beta

By Author: Jamie Hanson
Total Articles: 3495
Comment this article

Before you can balance alpha and beta you need to understand what the terms mean and how they apply to your portfolio. The following information will help you understand alpha and beta.

What is Alpha?
Alpha is a measurement tool to calculate risk and how it affects a particular investment. An investment's active return is called alpha, which is the amount of return beyond the anticipated return and the market's performance under the same amount of risk. Alpha coefficient is also used as a parameter of the CAPM, capital asset pricing model. Efficient markets have an alpha coefficient of zero. This means that an investment's performance can be evaluated by accounting for the involved risk. Alpha that is negative means the risk outweighed the return. However, if alpha is zero it means the benchmark was met and the return earned was worth the risk. Finally, if alpha is positive it means the reward was beyond the risk taken and a worthwhile return. When evaluating investments and even portfolios be sure to check the alpha beyond the percentage of return. Just because an investment has a return of 25% does not mean that ...
... it is actually as good as it seems. This is because its alpha could be negative, meaning the amount of risk taken was beyond the reward.

Beta
A statistical measure, beta determines the risk or volatility of a particular investment as it relates to the benchmark. It may seem similar to alpha, but just remember beta is associated with the risk and alpha is associated with the return based on the specific risk. When a fund has a beta that is close to 1 it means the fund is performing pretty close to its benchmark. If a beta is over 1 it means the volatility of the fund is higher than the market's overall volatility. When the beta is below 1 it means the volatility is not as high as the benchmark. For example, if a fund has a 2.5 beta that means the fund is expected to increase 2.5 times more than the index that corresponds to the fund. This means that if the corresponding index increases 10% then the fund would increase 25%. On the other hand, if the index decreases 10% then the fund would go in the opposite direction and lose 25%. Keep in mind, however, that it is not wise to judge a fund by its beta alone. The beta alone does not give an adequate picture of how the fund will perform and it should be considered along with the alpha and other statistical calculations.

Alpha measures a portfolio's return that is in excess of the market return after both are adjusted for risk. Investors seeking higher alpha can consider long short mutual funds as part of their core portfolio holdings.