If you can understand the numbers in the equity market, you can increase your gains. The chances of creating a successful portfolio are much higher for such investors. Key data pointers to consider in stock investing are alpha and beta. Once you understand these terms, you can use them to decide what kind of stocks are suitable for your portfolio. Let us discuss these terms and take the first step towards a successful portfolio.
What is alpha in the stock market?
The success of your portfolio or individual stock is measured by its alpha. It is also applicable to the mutual fund. It tells you how far a stock has outperformed the market. The basic stock market understanding is that when the market rises, most stocks price also increases. However, there are always some stocks that outperform the market. The price rise is more than the market. Why do some stocks outperform the market?
The answer is obvious – due to higher earnings and profit margins, etc. To find the alpha, you compare the stock to the benchmark index. It is the difference between the market returns and the stock return.
You can conclude that alpha is represented by a number based on the above information. Also, it can be both positive and negative. If the stock has outperformed the market, the value will be positive. If it has underperformed, its value will be negative. Your goal is to look for stocks with high positive alpha. If you can have many high alpha stocks in your portfolio, you can expect high returns from the market.
What is beta in the stock market?
We are sure you know of the simple risk and return equation – the higher the return, the higher the risk (and visa-versa). The alpha takes care of the return, but you still need to consider the risk before picking a stock.
The beta is the measure of a stock’s volatility and tells you the relative risk in comparison to the overall market. It informs you whether the stock is riskier or safer compared to the benchmark (index). Yes, every investor wants high returns, but not all want to take high risks. Hence, you should know the beta of stocks you shortlist for investment.
If the stock’s beta is 1, it tells you that it moves in line with the market. If the market falls by 10%, the stocks fall by 10%, and the other way around. A positive beta value tells investors that the stock moves in the same direction as the index. The negative value is an indication that the stock moves in the opposite direction to the market – when the market falls, the stock rises. Use the below pointers while evaluating beta:
Beta > 1 – Indicates that the stock is more volatile than the market. For example, a beta value of 1.05 tells you the share price is likely to fluctuate 5% more than the index.
Beta < 1 – It tells you that the stock price fluctuates less than the index.
How to use alpha and beta in investment?
Concepts are always good to learn, but you can become a successful investor only when you implement them. So let us see how you can use the above information in stock investment.
Assume you are long-term investors, and hence you will look for stocks that can outperform the overall stock market. You will look at the alpha of the shortlisted stocks and compare it with the performance of an index. You must ensure you tag stocks to the right index. Else the selection will go wrong. You can use alpha to:
- compare a stock against the performance of the index
- select the best companies as per investment goals
- rank different types of investment
Now assume you are someone who does not like market volatility. Or you are investing for short-term goals, and hence volatility is not good for your investment. In such cases, you can bring in beta to help you pick the right stocks (or mutual funds). It can help you pick stocks as per your comfort zone. Use beta for below:
- compare the risk of investment to an index
- align your investment with your risk profile
- find out the volatility of your selected stock compared to the index
Important note for investors
The alpha and beta are calculated based on the stock’s (and index) historical performance. Hence, the measurement does not guarantee a similar stock movement in the future.
The problem for investors
Even with the knowledge of stock’s alpha and beta, most investors are unable to pick the right company. There are two problems in front of investors:
- There are thousands of stocks in the market, and evaluating all the stocks is not possible for an individual investor.
- These are not the only two parameters that drive good returns – there are hundreds of other data pointers. It is not possible for investors to study all the pointers.
However, investors should not worry. We have created a solution to both the above problems – Jarvis Invest. It is an AI-driven platform that studies hundreds of parameters for all the listed companies in India and picks the best one for you – depending on your risk profile and investment horizon.
You don’t have to watch others make money from the stock market because you lack knowledge. You can too invest in the market and create wealth for yourself and your future generations.