Alpha, often referred to as an excess return or an abnormal rate of return is a term used to describe the ability of an investment strategy to beat the market. It is often used in conjunction with the beta, measuring the market's overall volatility or risk, known as systematic market risk, in comparison to the entire market or a benchmark. Alpha is a technical risk ratio which helps the investor in determining the risk-return profile of an investment. Beta is used in the CAPM model (used to calculate the cost of equity) as a beta coefficient.
Alpha, which may be positive or negative, is used as a measure of performance, showing when a trader, or a strategy, or a fund manager has performed better than the market over some period. It evaluates the performance of investment against a benchmark. Positive alpha means that the fund has outperformed the industry whereas the negative alpha means the underperformance of the fund with respect to the benchmark, representing the market movement. The zero alpha indicates the fund to be performing exactly same as the benchmark. The return generated over the benchmark index is the alpha, and it forms a part of active investing. Alpha is generally expressed in percentage terms. It shows the comparison between portfolio or fund performance with the benchmark index.
Active portfolio managers intend to eliminate unsystematic risk through diversification, further generating alpha in diversified portfolios and this alpha represents the value added or subtracted from a fund's return by that active portfolio manager.
Beta, on the other hand, shows the pattern of a stock’s returns to respond to fluctuations in the market.
Calculation of Beta:
? (beta) = Cov (Ra Rb) / Var (Rb)
Where, Cov (Ra Rb) is the covariance of an asset with respect to the market, and
Var (Rb) is the market variance
Beta helps an investor understand the direction in which the stock moves in comparison to the rest of the market and how volatile it is compared to the market. The analyst should use that benchmark for the calculation of the beta which is relevant to the stock. If the benchmark is not relevant to the stock, then it won’t be able to correctly identify how much risk the stock is adding to a portfolio. There might be some change to the risk of the portfolio if the stock deviates a little from the market, but it might not increase the theoretical potential for greater returns.
Beta can have a positive value or a negative value. A beta of 1.00 indicates the movement of the security to be correlated with the market. Adding this security will not affect the risk of the portfolio. If the beta of a security is below 1.00, but above 0, it shows less volatility of the stock with respect to the market. Adding this security will reduce the risk of the portfolio. A beta of more than 1.00 indicates that the security more volatile than the market and adding it will increase the overall risk of the portfolio. A negative beta indicates the inverse relationship of the stock to the market, i.e., the stock moves in the opposite direction to the market.
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