Share Market

As an investor it’s important for you to know what alpha and beta of stocks are. In a perfect scenario, the stocks would go up because of strong fundamentals and go down when earnings deteriorate. In reality however, this is not true. No doubt that fundamentals of the company play a huge and important role in its stock price, but psychology plays a big role in prices as well due to the inherit nature of any supply and demand marketplace.

There are times when the companies with strong and growing earnings are sometimes unjustifiably punished just because the whole market is going down. Beta was created to measure this only. Beta is nothing but a mathematical term that measures how a stock moves relative to an index.

The higher the beta, the more volatile it is against the index. For example, when a stock goes up by 20% while the index goes up 10% will have a beta of 2, while a stock with beta 1.2 means that the stock will go up 20% more than the index. When beta is seen as less than 0 then it means that the stock goes down every time the market goes up. If the stock moves exactly as the market does, the beta of it will be 0.

Therefore, stocks with low beta are the ones that are less volatile and therefore carry less risk. A very aggressive stock could have a very high beta.

In this term, if beta is the measure of how prices relate to the overall market then alpha measures everything else that affects the price of the security. High alpha stocks tend to rise even when the whole market falls. Thus it’s a very desirable attribute for a stock. In definitive terms an alpha is a measure of the buying pressure of the stock that is independent of the overall market forces. It’s not important that it’s related to the company’s strong fundamentals.

Alpha and beta are measures that help traders and investors in building their portfolio. For example, by constructing a portfolio with a mixture of betas, one can further diversify risks in our portfolio. But it is of importance to know that Beta and Alpha are backward looking, in the sense that they are historical data. Hence one must not just look at the numbers and assume low beta and high alpha is always good. Using them as another measurement to help your analysis is a good point.