In a class of 100 students suppose the average marks of students is 80 percent and one student scores 90 percent and other student scores 70 percent than the student who has scored 90 percent has positive alpha and the student who has scored 70 percent has negative alpha because the benchmark was 80 percent. Similarly, if there are two students while one student is scoring 80 percent over the past 2 years while other students score 60 percent in 1 year and 95 percent in the second year than the second student performance is said to be volatile and in stock market terms the student will be classified as a high beta while first student performance is stable and he will be considered as stable beta. Alpha and beta are the terms used in the context of stock markets performance and volatility, in order to have a better understanding about both terms one should look at some of the differences between alpha and beta with respect to the stock market –
Alpha VS Beta
Meaning
Alpha means that tool that measures the return which a stock or portfolio generates relative to a set benchmark of that asset over a period of time while beta refers to the volatility of stock or portfolio relative to a benchmark index.
Measure
Alpha is a performance measure and hence anyone looking to invest based on performance should look at the alpha of a stock or mutual fund while beta is a volatility measure and hence it is ideal for those people who want to know the risk before investing in a particular stock or mutual fund with respect to the benchmark index.
Interpretation
Interpretation of Alpha is when the alpha of stock or mutual fund manager is positive it implies that the stock or mutual fund manager has beaten the market benchmark and negative alpha means that the stock or mutual fund has underperformed the benchmark index. Interpretation of Beta is when the beta of stock or mutual funds is greater than 1 then it implies that stock or mutual fund is more volatile as compared to the benchmark index while if the beta of stock or mutual funds is lesser than 1 then it implies that stock or mutual fund is less volatile as compared to the benchmark index.
Example
An example of alpha is suppose a mutual fund manager based in the US who has managing index fund has delivered a 10 percent return over the past 1 year while the NASDAQ has risen by 8 percent over the last 1 year than alpha of mutual fund manager is positive implying that mutual fund manager has beaten the benchmark return by 2 percent over the past 1 year. An example of beta is suppose the index falls 4 percent but the stock falls by 8 percent or conversely if the stock rise by 8 percent on a 4 percent rise in the index than the beta of the stock is said to be 2 indicating that the stock is 2 times more volatile than the index.
Ideal Scenario
An investor would love to have stocks or mutual funds in his or her portfolio which have positive alpha and having a beta of less than 1 while getting rid of those stock or mutual funds from the portfolio which are having negative alpha and beta greater than 1.
As one can see from the above that both alpha and beta have many differences and that is the reason why any investor looking at investing in an individual stock or a mutual funds should look at alpha as well as the beta of stock or mutual fund and the only should invest in the respective stock or mutual fund so that investor can earn good returns at the same time managing the risk associated with the investment.