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Ask a Fool: What Do Alpha and Beta Mean in Investing?

By Matthew Frankel, CFP® – Mar 2, 2018 at 1:00PM

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These are two common, but often misunderstood investing terms.

Q: I've seen the terms "alpha" and "beta" used frequently in the financial news. What do they mean?

These terms refer to two important investing concepts.

In simple English, "alpha" refers to how well an investment performed relative to a certain benchmark index. Alpha tells you whether or not the investment outperformed (positive alpha) or underperformed (negative alpha).

For example, if you invest in a small-cap stock mutual fund that returns 15% in a given year, while the Russell 2000 index returns 10%, your fund would have achieved positive alpha for the year.

On the other hand, "beta" gives you information about an investment's volatility relative to the overall stock market. A beta of exactly 1 means that a stock, fund, or investment portfolio historically moves with the market, generally defined as the S&P 500. In other words, if the S&P 500 falls by 5%, a stock with a beta of 1 can be expected to do the same, absent any stock-specific catalysts.

A beta of more or less than 1 indicates that the stock should be more or less reactive than the overall market. For instance, if your portfolio's beta is 1.5, you can expect a 1.5% move for every 1% move in the market. A negative beta means that an investment moves in the opposite direction as the overall stock market.

For example, Johnson & Johnson has a beta of 0.7, meaning that it is less volatile than the overall market, while Amazon.com has a beta of 1.6, indicating that investors should expect higher volatility.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Matthew Frankel has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends AMZN and JNJ. The Motley Fool has a disclosure policy.

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