Stocks and the stock market in general are filled with risk and volatility. It is this very risk and volatility that makes investing in stocks potentially very profitable. When evaluating an investment or investment manager, two tools that are often used to judge the investment's performance relative to the market are alpha and beta scores.
Stock Market Risk
The stock market is inherently risky, driven largely by speculation and assumptions about the future. In general, the riskier a stock, the greater the return an investor hopes to make. This is considered a form of compensation for taking on the risk of the investment. This fundamental principal of finance is known as risk-reward.
Stock prices and the market as a whole can change in value wildly over the course of a day, or even a few minutes. The size of the upward and downward movements in a stock relative to its price is measured by a variable called volatility. The more volatile a stock, the greater the chance of high gains, but also the greater the chance of great losses. Most investors prefer a stock portfolio with strong, consistent gains and low volatility.
In investment management, an alpha score is a measure of the return on an investment in excess of the compensation for the risk borne. For example, if an investor is considering a particular stock that is fairly risky, he might determine that he will need a 10 percent return to be compensated for the risk he is taking. If that stock generates a return of 12 percent, the alpha for that stock is 2 percent.
A beta score measures the comparison of the volatility of a stock or portfolio compared to the market as a whole. If a stock has a beta of zero, this means that it changes in value completely independently of the market as a whole. If the stock has a beta greater than zero, the stock tends to move in the same direction as the market. And, if the stock has a negative beta, its price tends to move in the opposite direction of the market.
Leigh Richards has been a writer since 1980. Her work has been published in "Entrepreneur," "Complete Woman" and "Toastmaster," among many other trade and professional publications. She has a Bachelor of Arts in psychology from the University of Wisconsin and a Master of Arts in organizational management from the University of Phoenix.