Market Risk on One Side, Added Value on the Other

Beta measures how sensitive an investment is to movements in the overall market, while alpha measures how much the investment returned above or below what its level of market risk should have earned. A beta of 1.0 means the investment tends to move in line with the market, and a positive alpha means the manager delivered more return than the risk taken would predict.

The two work together. Beta tells you what return to expect for the risk, and alpha tells you whether the actual result beat that expectation.

An investor who sees a fund beat the market by 3 percent cannot judge it without knowing its beta. If the fund simply took more market risk, much or all of that outperformance may be beta rather than skill. For the full route from the exam to a career advising on these choices, our complete guide to how to become an investment adviser representative covers every step.

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What Beta Measures

Beta compares the movements of an investment with the movements of a market benchmark, usually the S&P 500. A stock with a beta of 1.5 has historically moved about 1.5 percent for every 1 percent move in the market, in either direction.

A beta above 1.0 describes an aggressive investment that amplifies market moves, and a beta below 1.0 describes a defensive one that moves less than the market. A beta of zero means the investment’s returns have no relationship with the market’s, and a negative beta means it has tended to move in the opposite direction.

Beta captures only systematic risk, the market-wide risk that cannot be removed by diversifying. The Series 65 Exam Preparation course at FRC covers beta alongside the other risk measures the exam tests, including standard deviation and the Sharpe ratio.

What Alpha Measures

Alpha is the difference between an investment’s actual return and the return expected for its level of market risk. A positive alpha means the investment did better than its risk predicted; a negative alpha means it did worse.

The most widely used version, known as Jensen’s alpha, uses the capital asset pricing model to set the expected return. The formula is: alpha equals the portfolio return minus the sum of the risk-free rate and beta times the market return minus the risk-free rate.

Alpha is the measure most closely linked to manager skill, which is why active managers advertise it. Because it is measured after fees, a manager has to produce enough excess return to cover their own costs before the investor sees any positive alpha.

Alpha and Beta Compared

How Beta Feeds Into Expected Return

The capital asset pricing model links beta to expected return. Expected return equals the risk-free rate plus beta times the market risk premium, which is the market return minus the risk-free rate.

With a risk-free rate of 4 percent and an expected market return of 10 percent, the market risk premium is 6 percent. An investment with a beta of 1.0 is expected to return 10 percent, one with a beta of 1.5 is expected to return 13 percent, and one with a beta of 0.5 is expected to return 7 percent.

Higher beta means a higher expected return, because investors demand compensation for taking more market risk. It does not mean the higher return is guaranteed, as high-beta investments fall further when markets decline.

Worked Example: Calculating Alpha

A portfolio has a beta of 1.2 and returned 13 percent last year. The risk-free rate was 4 percent and the market returned 10 percent.

Step one: the market risk premium is 10 minus 4, or 6 percent. Step two: the expected return is 4 percent plus 1.2 times 6 percent, or 11.2 percent.

Step three: alpha is the actual return minus the expected return, 13 minus 11.2, or 1.8 percent. The manager added 1.8 percentage points of value beyond what the portfolio’s market risk would predict.

Worked Example: Lagging the Market With Positive Alpha

A defensive fund has a beta of 0.6 and returned 8 percent in the same year, while the market returned 10 percent. At first glance, the fund underperformed.

Step one: the expected return is 4 percent plus 0.6 times 6 percent, or 7.6 percent. Step two: alpha is 8 minus 7.6, or 0.4 percent.

The fund trailed the market but still produced positive alpha, because it took much less market risk. For a client who wants lower volatility, this fund did its job well.

Study Risk and Return Measures With FRC

Performance measurement questions on the exam combine formulas with interpretation, and the most common mistakes come from mixing up what each measure captures. Our Series 65 course takes you through beta, alpha, standard deviation and the Sharpe ratio with worked examples and practice questions.

Consider studying with FRC for every exam on your route. Explore our USA exam courses, from the SIE through the Series 7, Series 63 and Series 65.

To take advantage of the membership, explore FRC Professional Membership, which gives you a verified Digital Profile that shows employers your real-time course progress, together with the Video Resume. Current offers are on our membership deals page.

Portfolio Beta

The beta of a portfolio is the weighted average of the betas of the investments in it. This makes beta a practical tool for setting how much market risk a client’s portfolio carries.

Worked example: a portfolio holds 50 percent in a stock fund with a beta of 1.4, 30 percent in a fund with a beta of 0.8 and 20 percent in Treasury bills with a beta of 0. Step one: 0.5 times 1.4 is 0.70. Step two: 0.3 times 0.8 is 0.24, and 0.2 times 0 is 0. Step three: the portfolio beta is 0.94, slightly less sensitive than the market.

If the market falls 15 percent, a portfolio with a beta of 0.94 would be expected to fall about 14.1 percent, while a single stock with a beta of 1.3 would be expected to fall about 19.5 percent. Advisers use these estimates to show clients what a downturn could mean for their money.

Systematic and Unsystematic Risk

Total investment risk has two parts. Systematic risk comes from market-wide forces such as interest rates, recessions and inflation, and affects almost all investments; unsystematic risk is specific to a company or industry, such as a failed product or a lawsuit.

Diversification can reduce unsystematic risk almost to zero, because company-specific problems tend to cancel out across many holdings. Systematic risk cannot be diversified away, which is why beta, which measures it, is the risk the market rewards.

Standard deviation measures total risk, both systematic and unsystematic. That is why beta is the better measure for a single holding inside a diversified portfolio, while standard deviation is better for judging an entire portfolio on its own.

Using Alpha and Beta When Building Client Portfolios

Advisers use beta to set a portfolio’s overall market exposure to match the client. A young investor with a long time horizon and high risk tolerance might hold a portfolio with a beta close to or slightly above 1.0, while a retiree drawing income might hold one with a beta of 0.5 or lower, mixing equities with bonds and cash.

Alpha is used differently. It helps advisers decide where paying for active management is worthwhile, and where a low-cost index fund that simply captures the market’s return is the better choice.

Many advisers combine the two in a core and satellite approach. The core of the portfolio is held in index funds with a beta near 1.0 for each asset class, while a smaller satellite portion is given to active managers who have shown consistent alpha in areas where skill has more room to work, such as small companies or less efficient markets.

Reporting matters too. When an adviser reviews performance with a client, separating the return that came from market exposure from the return that came from the manager’s choices helps the client understand what they are paying for, and prevents a strong market year from being mistaken for skill.

Worked example: a client’s portfolio returned 11 percent in a year when the market returned 12 percent, and the portfolio’s beta was 0.8. With a 4 percent risk-free rate, the expected return was 4 plus 0.8 times 8, or 10.4 percent, so the portfolio produced 0.6 percent of alpha while taking less risk than the market.

The Limits of Alpha and Beta

Beta is based on past price movements and can change over time as a company’s business or debt changes. It is only meaningful when the investment’s returns are closely related to the benchmark, which is measured by R-squared; a fund with a low R-squared may have a beta that says little about its real risk.

Alpha also depends on the benchmark chosen. Comparing a small-company fund with the S&P 500, for example, can make it look as if the manager added or lost value when the difference really came from the type of stocks held.

Positive alpha in one period does not guarantee it will continue. Studies of fund performance have long found that few active managers sustain positive alpha after fees over many years, which is one reason low-cost index funds, with a beta of about 1.0 and an alpha close to zero before costs, have grown so popular.

Alpha, Beta and the Treynor Ratio

The Treynor ratio measures excess return per unit of beta. It is calculated as the portfolio return minus the risk-free rate, divided by beta, and is most useful for comparing well-diversified portfolios.

Using the earlier example, a portfolio returning 13 percent with a beta of 1.2 and a risk-free rate of 4 percent has a Treynor ratio of 9 divided by 1.2, or 7.5. A higher Treynor ratio means more excess return for each unit of market risk taken.

The Sharpe ratio works the same way but divides by standard deviation instead of beta, so it captures total risk. The choice between them depends on whether the portfolio being judged is fully diversified or stands alone.

The Memory Aid

Remember “beta is the bumps, alpha is the bonus”: beta measures how bumpy the ride is relative to the market, while alpha measures the bonus return beyond what those bumps should earn.

For beta values, remember “above one amplifies, below one buffers”: a beta above 1.0 amplifies market moves, and one below 1.0 buffers them.

For the alpha formula, remember “actual minus expected”: alpha is the actual return minus the CAPM expected return.

Exam Traps to Avoid

The first trap is saying beta measures total risk. It measures only systematic risk; standard deviation measures total risk.

The second trap is assuming positive alpha means the investment beat the market. It means the investment beat the return expected for its risk, which can happen even when it trails the market.

The third trap is assuming a beta of zero means the investment is risk-free. It means returns are unrelated to the market, but the investment can still be volatile. The fourth trap is forgetting that alpha is measured after fees.

A Client Scenario

A client shows an adviser a technology fund that returned 14 percent last year, against 10 percent for the market, and wants to move most of her portfolio into it. The fund has a beta of 1.6, the risk-free rate was 4 percent and the client is 62, planning to retire in three years.

The adviser calculates the expected return as 4 percent plus 1.6 times 6 percent, or 13.6 percent, so the fund’s alpha was only 0.4 percent. Almost all of its outperformance came from taking far more market risk than the client’s current portfolio.

The adviser explains that in a 20 percent market fall, the fund could be expected to lose about 32 percent, a serious risk so close to retirement. The adviser recommends keeping the fund as a small part of a diversified portfolio and documents why the recommendation fits her goals and time horizon.

The Dictionary as a Video Library

The FRC dictionary is a study tool, not just a glossary. Every entry pairs a written explanation with deep-dive video, on-page quizzes and interactive flash cards, so you can read a concept, watch it explained and test yourself in one place.

Rules are covered in the same depth: open a rule and you will find the full explanation alongside video walk-throughs of how it applies in practice. Open the alpha, beta and CAPM entries to see each formula worked through on video and test yourself with the quizzes.

Practice Questions to Test Yourself

Question one: A stock has a beta of 0.7. If the market rises 10 percent, how much would the stock be expected to rise? About 7 percent.

Question two: A portfolio with a beta of 1.1 returned 12 percent. The risk-free rate was 3 percent and the market returned 9 percent. What is the alpha? 2.4 percent, because the expected return is 3 plus 1.1 times 6, or 9.6 percent, and 12 minus 9.6 is 2.4.

Question three: Which measure captures only the risk that cannot be removed through diversification? Beta, which measures systematic risk.

Question four: A fund returned less than the market but has a positive alpha. How is that possible? Its beta was low, so its expected return was lower than the market’s, and it beat that lower expectation.

Question five: What is the beta of a portfolio holding 60 percent in an investment with a beta of 1.5 and 40 percent in one with a beta of 0.5? 1.1, the weighted average of 0.9 and 0.2.

Turn Analytical Skill Into Career Evidence

Explaining risk and return clearly is one of the most important skills an adviser brings to client reviews. FRC’s Digital Profile shows employers the courses you are actively studying and the progress you have earned through assessed learning, verified by FRC, and a QR code on your resume takes them straight to it.

The FRC Video Resume lets a hiring manager hear you before the interview. Walking through why a fund’s outperformance was mostly beta, not alpha, shows the analytical judgment that investment firms look for.

Related Questions

Options are one way to reduce a portfolio’s market exposure without selling holdings, and our comparison of call option vs put option explains how a put can protect against a market fall.

Key Points to Retain

Beta measures how much an investment moves relative to the market, capturing only systematic risk, with 1.0 matching the market, values above 1.0 amplifying moves and values below 1.0 dampening them. Alpha measures the return above or below the CAPM expected return, calculated as the actual return minus the risk-free rate plus beta times the market risk premium.

A fund can trail the market and still have positive alpha if its beta is low, and a fund can beat the market with little alpha if its beta is high. Portfolio beta is the weighted average of the holdings’ betas, beta is only reliable when R-squared is high, and alpha is measured after fees.

For the role the exam leads to, read our guide to what an investment advisor representative is.