What are Low Beta & High Alpha Stocks?

Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.

When analyzing stocks and portfolios, investors often use the metrics alpha and beta. In this lesson, we'll define each of these terms and give some examples of how an investor might use that information to optimize their return.

The Market

Before we define alpha, let's make sure we understand the concept of a benchmark index. A benchmark index is a group of stocks that an investor is using as a standard to compare their own investments against. For example, when an investor says 'my portfolio is beating the market,' what do they mean? The market is a benchmark index, primarily represented by the Dow Jones Industrial Average, the S&P 500, or the NASDAQ. All of these include a defined number of stocks, and the increase and decrease of each of these indices is what is reported on the news each day as 'the market went up' or 'the market dropped.'

Alpha

The metric alpha is defined as the movement of a stock or portfolio relative to a benchmark index. An alpha of zero means that your stock or portfolio moves exactly the same as the benchmark index. If you are using the Dow Jones as your index and it closes the day up 1%, then your stock or portfolio would also close up 1%.

Very few stocks and portfolios have an alpha of zero; if they did, then there would be no use trying to pick individual stocks to make your own portfolio, because you could simply buy a fund that matches your benchmark and get the same return. So, an alpha above zero represents how much better your stock or portfolio performed over time than the benchmark, while a negative alpha means your stock or portfolio is underperforming the index.

Considering all this, what does it mean if you have a portfolio of five stocks and over the last quarter your portfolio has had an alpha of 6? It means your portfolio outperformed the index by 6%. Does that mean you made money? Maybe. If the index increased 2% over the same time, your portfolio increased 8%. If, however, the index dropped 10%, your portfolio dropped 4%. You still lost money, but not as much value as the benchmark index.

A word of wisdom about using alpha as a metric to judge the value of your stock: Use a benchmark index that is representative of your stock and portfolio. For example, the Dow Jones is an index that includes the 30 largest companies on the New York Stock Exchange. As established companies, their stock prices tend to be less volatile than a new tech company, for example. So using the Dow Jones as an index to calculate the alpha of your new tech company stock won't tell you much about how your stock is doing.

Beta

While alpha compares the rate of return on a stock or portfolio to a benchmark, beta measures the relative volatility of a stock. Volatility is a term used to describe how much a stock moves up and down. For example, a $50 stock that has a range of $48 - $52 on a certain day has more volatility than a $50 stock with a range of $49.50 - $50.50 on the same day.

Unlike alpha, which has a base value of zero, beta has a base value of 1. This is because beta is a multiplicative metric, meaning you multiply a stock's beta by the benchmark's rate of return, and you get an expected rate of return for your stock. For example, if your benchmark index rises 2% over a one month period and your stock has a beta of 2, you would expect your stock to increase 4% (2% * 2 = 4%). Hence, a beta of 1 results in the exact same rate of return (2% * 1 = 2%).

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