Emmy, a friend was recently filling me in regarding the Alpha and Beta of her mutual fund. I just smiled sweetly, while trying to remember if that supermarket chain went out of business or not. Can you tell me what she was going on about, please?
The Alpha and the Beta are two important investment risk indicators of mutual funds, stocks and/or bonds. These indicators are rather esoteric measurements for a financial product’s risks and rewards. They are significant aspects of modern portfolio theory, although rarely discussed outside the portrait-hung hallways of fancy financial firms.
Have I already lost your attention? I hope I’m not beginning to sound too much like your friend. Frankly, it’s difficult not to! I’ll try to define Alpha and Beta without too much jargon:
Let’s begin with the Beta. The Beta Coefficient compares the volatility of a specific product – for example Home Depot’s stock – with the volatility of the stock market as a whole. If an investment’s Beta is 1.0, then that investment’s value fluctuates exactly as the market does. This rarely happens. If an investment’s Beta is greater than one, then it is more volatile than the overall market. If the beta is less than one, then it is less volatile than the market average. Generally, lower price volatility, thus a lower Beta, is a good thing – especially if you prefer stability over the adrenaline rush of speculation.
The Alpha first factors in the Beta Coefficient for volatility, then measures the difference between an investment’s actual performance with its predicted performance. If in investment’s Alpha is zero, then everything went exactly as expected. Again, not a very common occurrence. When the Alpha is greater than zero, then that investment performed better than predicted. For example, if a mutual fund has an Alpha of five, then that fund performed five percent better than expected. A negative Alpha indicates that the investment is performing worse than anticipated.
So in short, an investment product with a high Alpha and a low Beta offers higher returns with lower risks. Who wouldn’t want that? Conversely, an investment with a low Alpha and a high Beta is would offer little return with high risk. A statistic best avoided.
Additionally, the Alpha may indicate the portion of an investment’s gain, or loss, that can be attributed to the financial manager’s skill – rather than the market’s movement on its own. Think of it as a gold star on a fun manager’s report card.
Thanks again to everyone for sending in your questions. Your input and participation is a vital aspect of this column. Please continue to email your questions or comments to email@example.com or call our office directly at (626) 943-8833. Mozel tov!
Securities and Advisory Services Offered Through NATIONAL PLANNING CORP.(NPC) Member FINRA, SIPC, a Registered Investment Adviser. EH Financial Group, Inc. and NPC are separate entities and unrelated companies