Money Matters: Alpha and Beta - not just Greek letters

While ‘Alpha’ and ‘Beta’ represent the first two letters of the Greek alphabet, they are also very meaningful in the world of investment management. You may have seen these indicators when researching your investments or heard your advisor speak of these two indicators not knowing exactly how they may impact your plan. In today’s quick pace and volatile markets, knowing how to use these indicators may provide additional tools in the management of your investments.

Beta, is simply the measure of an investment’s sensitivity to market movements. By definition, the market holds a beta of 1.0. The “market” can be represented by any index, such as the S&P 500® or US Treasuries. Generally, an investment is compared to an index of similar holdings, thus providing a hint of whether the investment will perform better or worse than the index. An equity investment is usually compared to the S&P 500, meaning the S&P 500 would hold a beta of 1.0, and the beta of the investment would be higher or lower based upon its historical risk when compared to this index.

If the investment’s market risk mirrors the index, then the investment would also have a beta of 1.0. However, if the investment’s beta is 1.10, this would imply the investment will perform 10% better than the index in good markets, but 10% worse in down markets. A beta of 0.80 means the investment performs 20% worse in good markets and 20% better in down markets.

It is important to remember, these are indicators and not “truths”. An investment with a beta of 0.75 can still perform worse than the index in poor markets. In difficult markets, seeking investments with a beta less than 1.0 can be beneficial, while shifting to investments with a beta higher than 1.0 during increasing markets may accelerate your returns.

But, what happens when an investment with a beta less than 1.0 consistently outperforms the market? Is the beta wrong? Not really. Researchers have created the indicator alpha to identify those investments whose actual returns are better than the expected performance when measured by beta.

So, alpha may indicate investments whose returns exceed what would be expected. A positive alpha indicates the investment has performed better than the expected results when measured by beta. A negative alpha naturally means the opposite, the investment has performed worse than the indicator beta predicted. Alpha may indicate the benefits or weaknesses of the portfolio manager when evaluating a mutual fund rather than an individual security.

Once you have an understanding of these two indicators, the selection of investments may change. This information may also explain past performance of some of your investments. While this next indicator is not another Greek letter, it is related to beta. The indicator is R-Squared. This statistic provides additional information concerning the accuracy of the indicator beta. A result of 100 would indicate all of an investment’s return is related to the movement of an index, when a low value would mean less of the investment’s performance is related to the index. This can be beneficial information when selecting investments. To demonstrate, you may be seeking an investment that would outperform the index by 15%, thus you found a mutual fund with a beta of 1.15. However, the R-squared for the fund is 40, thus implying only 40% of the fund’s performance is derived by the movement of the index. Based upon this information, you might expect a performance 15% better than the index over a long period, but the returns may not always move at the same time and in the same direction as the index.

Researching beyond the name of the fund and its performance history can provide meaningful insight into the risk you may be taking and the likelihood of your portfolio’s future performance. Management of investments is a profession; and when it comes to your retirement, one that is very important. If this is beyond what you would like to do during your retirement or is something you do not believe your current advisor is evaluating, then contact us as Quality Financial Concepts or one of the area Certified Financial Planners.


Would you like a response to a financial question? Send your question to Doug Horn, 115 W. Broadway, Maryville, TN 37801. Be sure to mark your envelope Money Matters.

Doug Horn, CFP, is an area financial planner with more than 24 years financial experience and founder of Quality Financial Concepts, located in downtown Maryville on Broadway.

Doug Horn, CFP, Registered Investment Advisor in Tennessee and Texas and Registered Principal, Branch Office of and Securities offered through CUE Financial, Member FINRA, SIPC.

© 2008 All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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