What to Do
To calculate alpha—in other words, to define the performance of a stock in relation to the rest of the market—a value for beta is needed. This involves some complex mathematics based on “linear regression analysis,” in which the weekly price of a stock is compared with corresponding changes in the overall market—usually over a period of two or three years. Happily, both alpha and beta values should be available from investment companies without going to all that trouble, but it’s still useful to know a bit about how it works.
Firstly, the overall market is given a beta value of 1.0. If a particular investment has a beta of—for example—0.6, its price is likely to move up or down by 6% when the market moves up or down by 10%. Another way of looking at it is to say that the price will move at about 60% of the level of overall market change.
Calcuating alpha is less difficult, as long as the figures required are easily obtainable.
The formula is:
Where the return on U.S. Treasury bills is taken as the value for a risk-free investment.
Example:
Suppose a stock with a beta rating of 1.2 returns 31 % over the period being considered, while the overall market returns 26%. U.S. Treasury bills return 4%. The stock’s alpha value would be calculated like this:
So the alpha value is 0.6, which means this particular stock returned 0.6% more than might have been expected, given the risk involved. An alpha of –0.6 would show that the stock returned 0.6% less than expected.
What You Need to Know
- alpha and beta start with the premise that the return on a security should be greater than the return on a “risk-free” investment.
- Utility stocks tend to have beta values below 1. On the other hand, high-tech stocks usually have a beta greater than 1—promising a better rate of return but with the higher risks associated.
- The success of a fund manager is frequently judged by their alpha score. But since alpha can be affected by outside influences, it’s not always an accurate reflection of performance.
Where to Learn More
Web Site:
The Motley Fool: www.fool.com
