Anyone who follows the financial news has probably heard the terms “alpha” and “beta” in relation to investing. However, it’s rarely explained how important they are when it comes to making investment decisions.
Alpha is a risk-adjusted measure of an investment’s performance. It takes the volatility of an individual investment and compares its risk-adjusted performance to a benchmark index.
The S&P 500, for instance, is a common benchmark for U.S. stock funds. The excess return (or loss) of the investment relative to that of the benchmark index is its alpha.
- A positive alpha means a fund has performed better than its benchmark.
- A negative alpha means the fund has underperformed its benchmark.
In short, the higher the alpha, the better.
Beta measures the volatility (risk) of an investment or a portfolio compared to the market as a whole. Think of it as the tendency of an investment’s return to respond to swings in the market.
An investment with a beta of 1.0 would move exactly in step with the market. An investment or portfolio with a beta of less than 1.0 means it would be less volatile than the market, and one with a beta greater than 1.0 would be more volatile.
A beta of 1.15, for instance, means the investment or portfolio’s beta is likely 15% more volatile than the market.
Essentially, if you’re looking for a lower-risk fund or portfolio, look for one with a low beta. If you’re willing to take on more risk in exchange for the potential of higher return, look for a higher beta.
In some of my future posts I’ll break down other industry terms and jargon.
Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc.