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This is the straight line that you see in Chart A, angling up and to the right.

A concept known as regression is then applied by calculating a least squares fit of the data points (see next paragraph for more detail). Those small diamonds are the data points. The returns of one are plotted on the X axis (abscissa / horizontal) and the returns of the other are plotted using the Y axis (ordinate / vertical). Have you ever wondered how academic finance calculates Alpha and Beta? You’re about to find out.Ĭhart A is known as a Cartesian coordinate system, sometimes (almost always) referred to as a scatter diagram, used often to compare two issues and derive relationships between them. A Beta of one means it moves just like its benchmark. If it goes up more when its benchmark goes up, then it has a higher Beta. Beta is more about the movement of the issue relative to its benchmark. Alpha in its loosest form is outperformance with whatever it is compared to, usually its benchmark.

I’m sure you have heard the media and money managers talk about Alpha and Beta. When I explain these things I just type in my own definitions, a purist might challenge some parts for exactness, but the concept is the goal. Sorry about the algebra, but I hope I will explain it so the formulae aren’t necessary. This article sort of ties in with the article I wrote about Modern Finance, “ So What Is It with Modern Finance?” I really questioned whether something like this belonged on, but finally decided that if it gave just a few folks some information that they deemed as valuable, it would be worth it.