Beta & Alpha – What An Investor Should Know

There are hundreds of methods and theories to manage investments. Many are complicated and you need a math background to understand how they work. Others are simple. The most basic premise is to understand the more risk someone is willing to assume in any investment the greater the potential for return. In other words an investor should be compensated for taking extraordinary risk. In order to do that investors should know two extraordinary measurements on gauging risk and return.

Beta and Alpha are terms used to define risk and return within an individual investment or a portfolio.

Let’s examine Beta. Every investment has risk and it can be measured against the index or market as a whole. For example assume you want to invest in XYZ Domestic Market Fund you would want to compare the Beta of the fund against the broader index the S&P 500. If the Beta registers 1.0 it means the fund equals the broader market as to risk. If the fund registers less than the number 1 it has less risk and if it is more than 1 it has more risk or volatility.

Alpha is a measure of risk adjusted performance. Given the amount of risk and the historical return the Alpha number provides the answer to how efficient the investment or portfolio. A positive Alpha represents the investment has outperformed its benchmark, and there is value in taking the greater risk, and a negative means the added risk or any risk is not increasing the value of the fund or portfolio. This can be explained that if someone pays for premium gas and expects increased efficiency but when it doesn’t it is a waste of money paying for the more expensive petro. If the Alpha is zero it means it simply matches the index or market.

You can find these numbers, not easily I may add, on any Morningstar analysis report. Your broker/dealer will also provide one or you can call your fund company to send you the numbers.

Remember the Beta will be measured against the dominant index. If you are comparing bonds it will be against the bond index or  the Lehman Aggregate Bond Index and if it is domestic equities it is the S&P 500 index. Make sure that whomever is doing the analysis keeps to those indices and doesn’t compare bonds to equities.

These are important numbers and when examining an investment with a high Beta don’t assume the risk will correlate with the return. You need to see the actual Alpha number to get the rest of the picture.

If you have questions call Paul @ 877 783 7080 or write him at pstanley@westminsterfinancial.com. Share this blog with someone who cares about their money.