Financial lexicology borrows from Greek, quite ironically so, given Greece’s financial situation. We will be covering the most common Greeks — alpha (α) and beta (β). This post is aimed at investors in all stages, to learn and revisit their knowledge of the Greeks. We will first define alpha and beta, and then conclude by showing how they can be calculated.
Beta (β)
Sensitivity of a stock’s returns with respect to portfolio returns, or the β% change in stock returns given a 1% change in the return of the market portfolio.
Oftentimes, investors are faced with the question, on whether they should add another investment to their portfolio. Capital Asset Pricing Model gives us the simple answer — look at the beta of the investment. Beta essentially measures the sensitivity of an investment’s return to the fluctuations of the portfolio’s return, due to the risks it has in common with the portfolio.
Given that investors, while trying to be on the efficient frontier of investments attempt to mirror the market portfolio, beta would thus tell us the systematic or market risk that the particular investment has in common with the portfolio in question. Why market risk? Remember that Investors can technically eliminate the firm-specific risk through diversification but as we know, market-wide risks cannot be eliminated.
Beta is calculated through a statistical formula, that finds the quotient of the relationship of the the investment to the portfolio by the spread (variance) of the portfolio. The average beta of a stock in the market is about 1; this means that the average stock returns tends to move about 1% for each 1% move in the overall return on the market portfolio. Stocks in cyclical industries tend to be more volatile and thus sensitive as revenues and profits from these sectors vary greatly over the business cycle. The betas on these stocks are highly susceptible to systematic risk and have betas exceeding 1. Stocks of non-cyclical firms tend to have betas that are less than 1, meaning that a change in market return would be reflected by the stock in a lesser magnitude than 1. Betas can be both positive, negative or zero.
Alpha (α)
The stock’s α measures the historical performance of the security relative to the expected return. It tells us whether or not the stock is undervalued or overvalued as it compares the fair and expected returns of the stock in the following manner: it compares the actual return of the stock to that derived from the best-fit risk-return regression line of the stock. To put it simply, the expected return of the stock is plotted against its beta, as beta is proportional to the common risks that the stock shares with the portfolio, and thus can be a measure of the riskiness of the stock. If the stock’s expected return lies above this best-fit line, it means that the stock is underpriced. If the stock has a lesser expected return than what can be derived from the best-fit line, it is overpriced. It is a risk-adjusted measure of the stocks historical performance.
Sources: Berk. Jonathan, Corporate Finance, 2017, Pearson.
Bodie, Kane, Marcus, Investments, McGrawHill, 2014.
Ankita is the author of this guest post. She is an undergraduate student at Sciences Po Paris, studying political economy and economics. She enjoys having a well diversified portfolio when it comes to areas of study, which gives her a holistic take on financial topics.
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