Understanding Alpha and Beta : A Simple Guide in 2024

Hi my pals! Welcome to our blog’s next article. We are going to look into the topic of Understanding Alpha and Beta, and why to consider Alpha and Beta for trading. Make sure to read the entire article through to the end if you want to understand Alpha and Beta completely. Thus, let’s get started right now!

Before getting to know everything about Alpha and Beta, we will get an understanding of What is Alpha and What is Beta.

In this blog we will be understanding What is Alpha and Beta.

1 What is Alpha and Beta ?
2 What is Alpha ?
3 What is Beta ?
4 Compare: Alpha and Beta
5 Examples of High Beta Stocks
6 What is Volatility ?
7 Example of Negative Alpha Stocks.
8 Why do Investors consider Alpha in Investing ?
9 How to calculate Alpha and Beta ?
10 Conclusion: Alpha and Beta

What is Alpha and Beta ?

Let me explain you what is Alpha and Beta in simpler terms

Once the level of risk assumed by an investment is factored in, alpha speaks to whether an investment is doing better or worse than the market. If it is positive then it means that your investment is better off compared to the whole market.

Beta represents the variation of a stock price with respect to the market fluctuations. If the stock has a beta value more than 1, then it is regarded as more volatile than the market, whereas, if its beta value is less than 1, then the stock is less volatile compared to the market.

What is Alpha ?

‘Alpha’ in the stock market represents the return of a particular stock against a standard or benchmark as the S&P 500. Define it as the extra or incremental value a particular stock or portfolio generates or destroys over the overall market index.

In other words, imagine the stock market as a race where the goal is to outrun a specific opponent (the benchmark). If your stock or portfolio (runner) is doing better than the benchmark runner, then alpha will give you this information. If your runner comes in at the first position, you have positive Alpha which typically implies better performance than the market. If your runner comes in last, your Alpha is negative, which means that your investment Return Underperformed.

The targeted by investors return is alpha that enables to inform about the performance of stock-picking strategy or investment portfolio surpassing the benchmark market index. A negative Alpha, on the other hand, means the investment didn’t perform as well as the benchmark, which isn’t ideal.

In short, Alpha reflects the skill or strategy of an investor or fund manager by showing how well they’re beating the market, rather than just riding its ups and downs.

What is Beta ?

Beta is a measure of the systematic risk or the magnitude of the response of a stock or a portfolio to changes in the overall show-case in the stock market. It tells you the extent to which a stock reacts to variations in the advertising.

It helps one understand it if you take Beta to mean how receptive a car is to the road. If the advertise is the street, Beta tells you how much your car (the stock) responds to bumps and curves.

Beta of 1: If a stock has a Beta of 1, it implies the stock moves in match up with the showcase. If the showcase goes up by 10%, your stock ought to too go up by 10%, and the same goes for losses.

Beta more noteworthy than 1: If a stock has a Beta higher than 1, say 1.5, it implies the stock is more unstable than the advertise. In this instance, your stock can rise by 15% based on the surge in the advertisement by 10%, while your stock can also decline by 15% if there is a corresponding dip in the advertisement by 10%. Thus, stocks with high Beta have a greater probability but also greater possible higher returns.

A figure below means that the volatility of the stock in question is less than the showcased portfolio. For instance, if beta is 0, it implies that the stock in consideration has a negligible volatility as compared to the market. 5, it could theoretically go up by 5% when the market is up by 10% and theoretically it could go down by 5% when the market is down by 10%. These stocks are seen as more steady but offer less emotional returns.

In basic terms, Beta appears how much a stock “responds” to the showcase. Higher Beta implies more potential for both higher picks up and greater misfortunes, whereas lower Beta implies less chance and steadier execution.

Compare: Alpha and Beta

Factor	Alpha	Beta
Definition	Measures a stock’s performance against a benchmark.	Measures a stock’s volatility relative to the market.
Purpose	Indicates how much extra return (or loss) a stock provides beyond the market return.	Shows how much a stock’s price moves in response to market fluctuations.
Benchmark	Compares against a market index like the S&P 500.	Uses the overall market (e.g., S&P 500) as a benchmark for volatility.
Interpretation	Positive Alpha means the stock outperformed; negative Alpha means it underperformed.	A Beta above 1 means more volatility than the market; below 1 means less volatility.
Risk Factor	Alpha is a symbol of ability or tactic and is not linked with risk.	Relative to market risk, beta occurs in association with prices.
Desired Outcome	Since positive alpha indicates performance that is above the market, it is the preferred result.	Thus, low beta may be preferred by the investor while high beta provides both increased risk and potential for higher returns.
Use in Investing	Used to judge a manager’s ability to outperform the market.	Used to assess how sensitive an investment is to market swings.

Difference between Alpha and Beta

In essence, Alpha measures how well you’re doing against the market, while Beta measures how much your stock bounces up and down with the market.

Examples of High Beta Stocks

Here are some examples of high beta stocks from the Indian stock market. undefined

Tata Motors: By being a member of the auto industry, there is a very high Beta for the Tata Motors since it adapts well to changes in the economy, consumer preferences, and the global market especially in the auto sector.

Adani Enterprises: Known for its volatile price movements, Adani Enterprises is involved in various sectors such as infrastructure, mining, and energy, and its stock price can be highly sensitive to market changes and news related to its projects.

JSW Steel: As a major player in the steel industry, JSW Steel’s stock price can be volatile due to changes in global commodity prices, demand-supply dynamics, and economic conditions.

India bulls Housing Finance: Being part of the financial sector, India bulls Housing Finance often shows high Beta, reacting to interest rate changes, regulatory news, and overall market conditions.

Bank of Baroda: As a public sector bank, Bank of Baroda can exhibit high Beta, especially in response to interest rate changes, financial market conditions, and government policies.

These stocks tend to move more aggressively with the market, making them riskier but potentially more rewarding in terms of returns during bullish phases.

What is Volatility ?

Volatility of an investment in the stock market implies the extent to which the price of a stock or other asset varies over time. It is quite similar to the unpredictability of the stock and its fluctuating moods, or being high and low at some time, and normal at other times.

When a stock is volatile, its price can change quickly, going up or down sharply within a short period. For example, one day the stock might be worth a lot more, and the next day it could drop significantly. High volatility means more uncertainty because you don’t know where the price will go next.

Conversely, low volatility suggests that the stock price is less likely to swing up and down and there is less likelihood of sharp changes in stock prices.
Loosely speaking, volatility is the measure of how bumpy a ride is for a stock ; the more bumps, or price variations, the higher the volatility.

Also, I have provided Wikipedia link of Volatility.

Example of Negative Alpha Stocks.

Negative Alpha stocks in the Indian stock market are those that have underperformed compared to their benchmark index (like the Nifty 50 or Sensex). These stocks have not delivered returns that match or beat the overall market, indicating they didn’t live up to investor expectations or faced specific challenges.

The following stocks are a few instances of stocks that may have occasionally displayed negative Alpha:The following stocks are a few instances of stocks that may have occasionally displayed negative Alpha:

Yes Bank: Since it was one from the best stocks relating to banking industry, Yes Bank experienced bad loans and fluctuating capital. Its performance for an extended period of time was slightly below the market average, making the Alpha negative.

Vodafone Idea: Despite its customer friendly polices this telecom provider has faced severe financial constraints such as having heave debt problems and strong regulations. It has a low P/E ratio and in stock market context its price /earnings ratio has been low; often negative Alpha is given by it.

Jet Airways: Before the company shut down its operations, it had been making losses and has had a negative Alpha due to some factors as follows;

Suzlon Energy: As a result of operational and financial challenges, the wind energy company was lagging behind the market average for quite sometime.

Reliance Capital: This company belongs to the Anil Ambani group and looks like any corporate heavy weight out of water in terms of stocks periodically showing negative alpha and giving a raw deal to investors for years due to debt and other related problems.

In summary, negative Alpha stocks are those that don’t keep up with the broader market’s growth, often due to company-specific problems, poor management, or external factors. Investors in these stocks would have seen lower returns than if they had simply invested in the market index.

Why do Investors consider Alpha in Investing ?

Since, Alpha can inform an investor if an investment is outperforming the entire market or not, investors make use of Alpha in their decision-making processes. Alpha holds the ability to suggest whether a certain portfolio, mutual fund, or stock is delivering extra returns in addition to just simply indexing the market’s return.

Here’s why it matters:

Measuring performance: Alpha gives investors a clear picture of how well their investment is doing compared to a benchmark (like the Nifty 50 or S&P 500). A positive Alpha means you’re getting better returns than the market, while a negative Alpha indicates you’re lagging behind.

Judging skill: Investors use Alpha to see if a fund manager or their own stock-picking strategy is adding value. A consistent positive Alpha suggests that the manager or strategy is skillfully beating the market, not just benefiting from market-wide gains.

Potential identification: Alpha supports investor’s decisions on investments. The future returns can also be higher in case the investment has a positive Alpha history, which shows it indeed was superior to the market.

Risk-adjusted returns: Alpha takes into account both the returns and the risk of an investment. This is important because it tells you whether the additional profit that you are reaping just offsets the risk that you are undertaking.

In the simplest terms, investors employ Alpha to measure how well their portfolio is performing compared to the market or an appropriate benchmark. All investors desire positive alpha since it is evidence that they are beating the market rather than merely mimicking it.

How to calculate Alpha and Beta ?

How to Calculate Alpha:

Alpha is determined by comparing your investment’s actual return to your expected return given the market’s return and the amount of risk you are accepting (Beta). The equation for alpha is:

Alpha =( Actual Return −Risk-Free Rate ) − Beta × ( Market Return − Risk-Free Rate )

Actual Return: The percentage return your stock or portfolio has generated.
Risk-Free Rate: The return you would get from a risk-free investment, like government bonds.
Beta: The measure of how much your investment moves in relation to the market.
Market Return: The return of the market index (e.g., Nifty 50, S&P 500).

In simple terms, Alpha tells you how much extra profit (or loss) you’re making beyond what the market offers, adjusted for the risk you’re taking. If the result is positive, you’re outperforming the market; if it’s negative, you’re underperforming.

How to Calculate Beta:

Beta measures how much your stock or portfolio moves compared to the overall market. The formula for Beta is:

Beta = (Covariance of Stock and Market Returns) / (Variance of Market Returns)

Covariance of Stock and Market Returns: This shows how much your stock’s returns move in relation to the market.
Variance of Market Returns: This measures how much the market’s returns are fluctuating overall.

Above, we shown how to calculate Alpha and Beta

In simpler terms, Beta tells you whether your stock is more or less volatile than the market. A Beta of 1 means your stock moves exactly with the market, a Beta above 1 means it’s more volatile, and a Beta below 1 means it’s more stable than the market.

For Alpha: Imagine you invested in a stock and earned a return of 12%. The market gave a 10% return, and your stock has a Beta of 1.2 (meaning it’s a bit more volatile than the market). If the risk-free rate is 2%, Alpha will help you see whether your 12% return is good, given the extra risk you took by investing in a more volatile stock.

In regard to beta, if a stock is said to have a beta of 1. 5 and the market goes up by 10%, your stock should go up by as much as 15%, should it? Implied volatility In this case, if the market declines by 10%, then your stock could decline by 15%. It is more useful for understanding such kinds of swings with beta.

These computations can help investors in determining whether or not they are making the right choices and managing their risks accordingly.

Conclusion: Alpha and Beta

However, you will find that Alpha and Beta are simply tools for measuring the risk and return of an investment. Both are helpful in the evaluation of investments, but it has to be said that these coefficients are based solely on history. It is important to note that the past performance of a stock does not necessarily mean that it will perform in the same manner in the future. Similarly, a stock’s beta – or volatility – can vary from one period to another. That is why in spite of the fact that Alpha and Beta gives useful information on the market, they cannot foresee what the market will do in the future.

In this blog, we have provided information about Alpha and Beta “What is Alpha and Beta ?, What is Alpha ?, What is Beta ? , Compare Alpha and Beta, Examples of High Beta Stock, What is Volatility ?, Example of Negative Alpha Stocks, Why do Investors consider Alpha in Investing ? How to calculate Alpha and Beta? ”

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If you want to learn from the basic of stock market, I have mentioned few links below for starters

Read this —

Understanding Alpha and Beta : A Simple Guide in 2024

What is Alpha and Beta ?

What is Alpha ?

What is Beta ?

Compare: Alpha and Beta

Examples of High Beta Stocks

What is Volatility ?

Example of Negative Alpha Stocks.

Why do Investors consider Alpha in Investing ?

How to calculate Alpha and Beta ?

How to Calculate Alpha:

How to Calculate Beta:

Conclusion: Alpha and Beta

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