(eToro Blog) Investors are always hopeful that their investments are performing at maximal levels, and gauging that performance is important, as are the tools necessary to perform the test. Two of the most useful ways to assess performance is with alpha and beta, which are risk ratios that can be used to statistically measure and calculate returns. Both Alpha and Beta can be used to help a trader determine the profits or losses, i.e. the risk-reward profile, of their investment portfolio.

Alpha is the historical measure of an investment’s return compared to the expected return, adjusted for risk. Beta is the historical measure of an investment’s volatility relative to a benchmark.

Alpha measures an investment’s performance by comparing it to a benchmark, typically the SPX500. Alpha calculates the excess returns from the weighted average of an investment within a particular group (asset type, investment type or goal) over its benchmark. The weighting is based upon the product, or ending value, which is usually of EPS or earnings per share. It mathematically estimates an investment’s return, and is usually based on the growth of EPS. The formula for alpha, expressed as an annualized return percentage, is:

Return = (End price + Distributions per Share – Start Price)

Start Price

Beta is based on volatility of a stock or a mutual fund, and it like alpha it is compared to some benchmark. Beta, in essence, is how well an investment’s return responds to market fluctuations. In this case, an investment’s beta calculation is the simple monthly returns across a specific period of time. The formula for beta as a simple monthly return is expressed thusly:

Return = (End price + Distributions per Share – Start Price)

Start Price

Then the results of alpha and beta are compared to the specific benchmark, in this case the SPX500. For alpha, a positive result of 1.0 would mean that the stock outperformed the benchmark by 1% while a negative result of -1.0 would mean the stock underperformed the benchmark by 1%. For beta, a result that is less than 1 is indicative of a stock that is less volatile than the comparative market, while a result greater than 1 shows that volatility greater than the market. In theory, if the investment’s beta result is say 1.2, that means its 20% more volatile and thus subject to bigger swings in the price than the market.

Let’s say we’ve done our calculations for a particular stock and are assessing the alpha and beta. Toogoodtobetrue’s stock had an annual return on investment of 12% and a positive beta of 1.5. The SPX500, our benchmark, was up 10% over the same period.

The 1.5 beta indicates that the stock was 50% more volatile than the SPX500; to compensate for owning a higher risk stock, the return should have been better than 15%, but it was only 12%, 3% lower than the rate needed to offset the risk. The Alpha then was -3, indicating that it’s not that a good an investment despite the fact that the return was better than the benchmark.

For some investors, a high alpha with a low beta is the preference, while other investors would prefer a higher beta and try to take advantage of the volatility to sell the investment at a higher price.

Note: Past performance is not an indication of future results. This post is not investment advice. CFD trading bears risk to your capital.

3A%2F%2F0.gravatar.com%2Favatar%2Fad516503a11cd5ca435acc9bb6523536%3Fs%3D30&r=G /%Amos Meiri