What is alpha?

Alpha in finance

Alpha is a measurement of the performance of an investment as compared to an index such as the S&P 500. It is considered to be an investment’s active return and is used to understand how an investment is performing as compared to the market as a whole.

An alpha number can be negative or positive, and the baseline value is zero. For example, if an investment has an alpha value of two, this means that it has outperformed the comparison market index or benchmark by two percent. By contrast, if an investment has a negative value of one, this means that it underperformed the market by -1 percent. Alpha can be used to determine how well a portfolio manager is actually performing for you.

How is alpha defined, and how can you measure alpha?

In investing, the definition of alpha is the excess or abnormal rate of return of an investment.

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A simple alpha calculation can be completed by subtracting the total return of an investment from a benchmark that is comparable in the same asset class. However, this type of basic calculation can only be used to compare the performance of an investment to a benchmark in the same category of assets. More complex measurements of alpha, such as Jensen’s alpha, also take into account risk-adjusted measures and the Capital Asset Pricing Model (CAPM) theory by using the beta and the free risk rate.

What is alpha in investing?

When you use alpha in investing, it provides you with a way in which you can see how a fund performs as compared to its benchmark over time. A fund’s excess return as compared to the benchmark is a positive alpha. When you are investing, you always want to have a positive alpha. If you instead have a negative number, the fund that you have chosen is not performing as well as the benchmark.

Investment alpha helps you to set and meet a goal of outperforming the market. When you use investment alpha, you can make adjustments to your portfolio as needed. If you do not pay attention to alpha, beta, and correlations when you are investing, your portfolio may not earn as great of returns as it otherwise might.

Calculation of alpha

Alpha is also known as the Jensen index after its creator, Michael Jensen. Jensen created Jensen’s alpha in the 1970s to measure the highest possible return for the least amount of risk. It is used to determine what the required excess return of a portfolio, stock, or security is.

When you want to calculate the investment alpha, it is important that you choose a relevant benchmark. While many investors choose the S&P 500 as the go-to benchmark to use, it may not be the most appropriate for some portfolios.

For example, if a portfolio is invested in the transportation sector, the S&P 500 may not be a good choice for the benchmark. Instead, an index such as the Dow Jones Transportation Average might be a more relevant option. Comparing different types of portfolios that contain different asset classes with their alpha ratios may also provide you with misleading and inaccurate numbers.

Volatility and risk

Volatility and risk are two important terms within finance, and they should not be confused. Some people make the mistake of equating the two terms or using them interchangeably.

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The risk of an investment refers to the potential to permanently lose money. By contrast, the volatility of an investment refers to the fluctuations of the price that can occur and how rapidly those changes happen.

When prices fluctuate, it doesn’t necessarily mean that there is a risk of permanently losing money. Volatility instead simply refers to the changes that happen and does not refer to the risk of permanent loss.

What is beta vs. what is alpha?

The investment beta or β refers to a measurement of the volatility of a portfolio, stock, or security as compared to a benchmark or an entire market. When β is calculated, it is the tendency of the returns of a security or stock to respond to price fluctuations in the market.

It is used in the CAPM, which is used to calculate the expected return of an investment asset. To calculate β, the most common formula used is as follows:

β = COV(RaRb) / Var(Rb)

Difference between α and β

The meaning of alpha is a measure of an investment’s active return as compared to a relevant market or benchmark. An investment’s excess return as compared to the benchmark’s return is its investment alpha.

The investment beta is a measure of the systematic volatility of the returns in relation to price fluctuations. Both α and β are important in calculating the actual performance of a portfolio, security or stock, and can tell you how well a portfolio manager or robo-advisor is performing when they are used in an appropriate formula using a relevant benchmark or market index.

Application of alpha and the correct approach to alpha

To correctly apply investment alpha with your portfolio, it is important for you to understand what is alpha and how to calculate it correctly. The meaning of alpha in terms of finance is the abnormal rate of return that your portfolio earns as compared to a relevant benchmark or market index.

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If you choose a benchmark or index that represents a different asset class, the numbers that you calculate will be meaningless, telling you little about the performance of your portfolio and how it should be performing as compared to how it actually is. Understanding alpha can give you an edge so that you might consistently outperform the market.

Jensen’s alpha

Jensen’s alpha refers to the measurement index that was created in the 1970s. This measurement index is based on the idea that riskier investments should provide higher returns than lower-risk investments.

When investments provide higher returns than the expected returns, the investors who hold them are said to be outperforming the market. Consequently, the goal of most investors who understand the concept of alpha seeks to attain a positive alpha for their investments and portfolios.

Challenges of using alpha

Using alpha presents several challenges for investors. It can be difficult to calculate for some people. People who try to compare portfolios of different types of assets will derive alpha numbers that are misleading.

While using a basic calculation of alpha can give a rough comparison of a portfolio against a benchmark of a similar asset category, it may not take into account the effects of volatility and risk of more advanced formulas. Investors might gain more of an edge relying on a robo-advisor that calculates alpha automatically and readjusts the investments in the portfolio accordingly.

Efficient market hypothesis

The efficient market hypothesis states that the market is accurately valued because all of the information has been priced in. If this hypothesis is true, then it would mean that active profile managers do not have an edge over other investors.

While people might question whether investing and portfolio management is more a matter of luck or skill, some actively traded funds struggle.

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Capital asset pricing model

The capital asset pricing model is an equilibrium model that can be used to determine what returns an investor needs to realize in order to balance out a particular degree of risk. It takes into account both the alpha and the β measurements, using a formula that can be expressed as follows:

R = Rf + β(Rm – Rf) + Alpha

In this formula, the coefficients represent the following measurements:

R is the return of the portfolio

β is the portfolio’s systemic risk

Rf is the risk-free rate of return

Rm is the market return

The formula can be rearranged as follows to solve for alpha:

Alpha = R – Rf – β(Rm-Rf)

When the formula is rearranged to solve for alpha, you can then determine how much an investment outperformed or underperformed the selected market or benchmark.

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