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Whether you invest in funds or stocks, understanding investment terms like alpha and beta can help you take more informed investment risks

Alpha and beta: How to use these terms for a better investment portfolio

Are you familiar with the terms alpha and beta in investing? What they mean and, more importantly, how they can help you become a smarter investor?

Beta: A measure of volatility

Beta measures an asset’s historic volatility relative to an underlying benchmark index. Take the example of a stock listed on the Singapore Exchange with a beta value of 1.2. This means that based on past data, the stock is 20% more volatile than the underlying benchmark index. So, if the underlying Straits Times Index moved by 10%, the stock moved by 12% in the same direction.

Beta values and their implications:

  • 0 : Zero correlation with the underlying benchmark index; cash has a beta of zero
  • Between 0 and 1 : The asset moves in tandem with the market but at a lower volatility
  • 1 : The asset is perfectly correlated with the market. For example, an Exchange Traded Fund that tracks the S&P 500 should have a beta of 1
  • Higher than 1 : The asset moves in tandem with the market but at a higher volatility
  • Negative beta : The asset moves in the opposite direction of the market.

In other words, the higher the beta, the higher the volatility and risk.

Interpreting beta values

Knowing beta values allows you to better understand the assets in your investment portfolio. So if your portfolio consists purely of stocks with beta values higher than 1, it is on the riskier side.

However, there are two caveats:

  • Beta is historical : Beta values are calculated based on the historical performance of an asset. There is no guarantee its beta will not change in the future.
  • Beta only measures systematic risk : Beta values measure the level of historical correlation with the overall market, so they only capture systematic or market risk. They do not account for other types of risks such as credit or liquidity risk of the asset.

Alpha: A measure of return

Alpha measures the return of an asset compared to the underlying benchmark index. Hence, while beta is a measure of systematic risk and volatility, alpha is a measure of excess return.

Let’s say over the last year, the Straits Times Index returned 4% and the stock returned 10%, or 6% over the benchmark index; this would give the stock an alpha value of 6. If the stock had instead lost 2% in value, it would then have an alpha value of -6.

Measuring performance with alpha

Alpha values are typically used to rank the performance of actively-managed mutual funds and their investment managers. A higher alpha shows that a particular fund often outperforms the market. You can also use alpha values to check the performance of a particular security against the benchmark index.

Again, two caveats when interpreting alpha values:

  • Alpha is historical : Similar to beta, past alpha value does not imply future alpha value.
  • Check the benchmark : Inappropriate benchmarks can often inflate alpha values. For instance, if a fund invested mostly in riskier technology stocks but benchmarked against a large cap market index like the S&P 500, then the alpha value (assuming a profitable year) might seem very high. However, a more aligned index such as the NASDAQ, which focuses more on the technology segment, would have shown a lower alpha value.

How to use alpha and beta for your own investment portfolio

If you actively invest in mutual funds or stocks, understanding alpha values can help you gauge their performance. For stock investors, beta values can help you better gauge risk levels and structure your investment portfolio appropriately.

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This article is brought to you by Standard Chartered Bank (Singapore) Limited. All information provided is for informational purposes only.

Disclaimer:

This article is for general information only and it does not constitute an offer, recommendation or solicitation to enter into any transaction. This article has not been prepared for any particular person or class of persons and it has been prepared without regard to the specific investment or insurance objectives, financial situation or particular needs of any person. You should seek advice from a licensed or an exempt financial adviser on the suitability of a product for you, taking into account these factors before making a commitment to purchase any product. In the event that you choose not to seek advice from a licensed or an exempt financial adviser, you should carefully consider whether the product is suitable for you. You are fully responsible for your investment decision, including whether the investment is suitable for you. The products/services involved are not principal-protected and you may lose all or part of your original investment amount.