Is Alpha Beta a new fraternity? Or maybe a text code for “Happens an AL-PHA-lot” or, “Let’s-BET-A-gain?” The answer is neither. However as an investor, and if you want a shot at having a successful investment portfolio, then you need to know Alpha & Beta and the roles they play. All investors must accept that risk is a part of financial life, as well as everyday life. However, if you can learn to control and minimize risk, then you can increase your likelihood of success. For example, if you drive in a newer automobile and are involved in an accident, you have minimized the risk to yourself due to seat/lap belt use, airbags, anti- lock brakes and crumple zones. However, if you choose to drive a classic or antique car equipped with only a lap belt and none of the other protections offered by newer cars, then you have certainly taken on greater risk in the event you are involved in an accident.
The amount of risk one takes financially or otherwise is directly correlated to the knowledge, understanding, planning and time taken to address the specific issue and/ or concern at hand. In relating risk minimization to the world of finance and investing, those investors with an awareness of Alpha & Beta stand a greater likelihood of success. Alpha and Beta measure a security’s (stock’s) performance, adjusted to risk, compared to the overall market behavior. As an example, think of it as follows. In sports such as football and baseball, coaches expect their most accomplished players to perform at a higher level than the other players. In the investment arena investors expect more from higher risk investments than the general market and Alpha and Beta can provide an indication of how risky a stock or mutual fund is. Alpha is defined as the return a security or a portfolio would be expected to earn if the market’s rate of return were zero. A larger positive Alpha indicates a strong performance, while a large negative Alpha indicates a dismal performance.
Beta measures the volatility (risk) of a stock or fund in comparison with the market as a whole. The market itself is assigned a beta of 1.0. Therefore, if a stock or fund has a beta of 1.2, it would mean that the price of that stock or fund is likely to rise or fall by 12 percent when the overall market rises or falls by 10 percent. Accordingly, if the Beta was 0.7 the stock or fund price is likely to move up or down at 70 percent of the level of the market change. To calculate a stock’s Alpha rating you first need to know the stock’s Beta rating, and calculating Beta can be a challenge. Suffice it to say that unless you enjoy linear regression analysis, Beta calculations involve mathematical complexities best left to those who understand doing them. The good news is that these calculations are readily available from investment firms as these figures are generally included in standard company performance reports.
Remember that when building or modifying an investment portfolio these numbers are important for you to be aware of. When you invest in a stock with a Beta of 1.7 and the market goes down 10 percent and your stock goes down 17 percent it should come as no surprise to you. The higher the Beta the greater the move will be either up or down versus the overall market. Many investors have made the mistake of thinking they are invested in a conservative fund or stock that should move in lock step with the overall market. Unfortunately, the bigger the Beta in a market decline, the larger the loss. Maybe it’s time for you to visit with your advisor and discuss how best to put Alpha & Beta to work for you. Ed Maass is a Certified Financial Planner, Chartered Financial Consultant, and Chartered Life Underwriter. Located in Delray Beach at 74 NE 4th Ave. Suite #3, you can contact him directly at 561-272-0663 or by email at Ed@PhysiciansWealthCare.com