Understanding the alpha and beta of the market

Alpha measures the excess return and beta measures relative volatility

You might have come across stock market geeks talking about the alpha and beta when talking about stock returns. Alpha and beta are important tools used to understand the concept of return. Both of them are on based on historical performance, and both of them are relative measures. Let us understand both these concepts in depth. 

Alpha: 

In simple terms, alpha is the return generated over a benchmark index. It simply is an indicator of how well or worse your portfolio has performed compared to a benchmark index. 

For example, if your portfolio of stocks has generated a return of 18 per cent in a year and say Sensex or Nifty has delivered a 15 per cent return, then your portfolio’s alpha will simply be 3 (conventionally represented as the number and not percentage). A higher alpha is what investors aspire to. Alpha is widely used to measure the performance of fund managers. A fund manager generating consistent and steady alpha become a preferred choice for investors. 

However, empirical evidence has shown that beating the market is not as easy and sustainable as it seems. In fact, passive investing i.e. simply investing in a benchmark portfolio has generated strong returns over time. 

Beta: 

Beta is the measurement of the volatility of a stock, fund or portfolio relative to that of a benchmark index. Although Warren Buffett doesn’t consider volatility as a risk measure, many investors consider volatility as a risk measure and hence like to check the beta of a stock. Beta has a base of 1 which is basically the proxy of the volatility of benchmark index. And so, if a stock is more volatile than the benchmark index, then it will have a beta higher than 1 and vice-versa. A beta of 1.2 indicates that the stock is 20 per cent more volatile than benchmark. Beta is usually referred to as beta coefficient because of its application in various equations.