We've learned about what alpha and beta can tell us for an individual stock or asset's risk.
Once we’ve started investing, we can start to understand the success of our portfolio by looking at our portfolio’s alpha and beta.
We can look at the two major components of investing, return and risk, by using alpha and beta to gauge performance.
Since alpha measures the risk-adjusted return relative to a benchmark, it lets us know if our portfolio did well compared to an index. If our stock selections outperformed the market, our portfolio will have a positive alpha.
On the other hand, beta measures the amount of risk relative to a benchmark so it will let us know how much risk we are taking compared to the market. Since it changes over time, it will also let us know if we are taking more or less risk than we had started out with. Knowing this will help us make sure we aren’t taking more or less risk than we are comfortable with.
Using both alpha and beta will give us an idea of whether or not we are getting high enough returns for the level of risk that we’re taking.
Using these metrics to change your portfolio
We can control how much risk we are willing to take in our portfolios. Adding more lower beta investments, such as bonds, will lower the beta of the portfolio and therefore lower the amount of relative risk. Adding more higher beta investments, such as high growth stocks, will raise the beta of the portfolio and therefore increase the amount of relative risk.
We cannot adjust our portfolio’s alpha the same way we can adjust our portfolio’s beta since we can’t guarantee excess risk-adjusted returns; however, we can use it on the investment level to inform which of our investments are underperforming and if we need to change up some of our selections to higher-performing ones that have a similar beta.
During periods of economic expansion, one strategy is to take on more risk, increase beta, to capture a higher return while the markets are rising. Then during periods of economic recession, lower the risk in the portfolio by lowering beta so that your potential losses are lessened if the market crashes.
If your portfolio has a negative alpha, then you’ve underperformed the benchmark. Don’t feel discouraged because most professional managers underperform compared to their benchmarks most of the time. This just means you can look at the investments you hold and replace some underperforming ones with higher-performing ones. Otherwise, investing in passive index ETFs or Mutual Funds is another alternative.