Like most worlds, investing has its own terms. I can’t remember when I first heard the term alpha in stocks and investing, but it must have been over 25 years ago. Since then it has become a very common part of my vocabulary as a financial advisor and part of the management team at broker-dealer.
So what is Alpha in stocks? The term alpha in stocks denotes an investment strategy’s ability to generate excess return minus costs above a market index. The term “Alpha” started originally when a portfolio manager that achieves a positive alpha will outperform a market index by enough to cover not only his/her own costs, but also to earn additional profit from the risk he/she is taking.
Alpha generally means excess return (greater than a risk-free market return, such as the one earned by a simple bond) on an investment portfolio. In other words, the ratio of the excess return to the risk-free rate. In this article, alpha refers to excess return.
In finance, there is an alternative interpretation to alpha that differentiates it from beta, rather than risk/reward profile as is done in academia. This alternative interpretation is also sometimes used to describe any investment strategy that seeks above-market returns, including Dynamic asset allocation strategies and efficient frontier strategies.
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Nowadays, alpha is also sometimes used as a general term to describe any investment strategy that seeks above-market returns. However, the alternative interpretation could be considered misleading, as alpha generally means the excess return on an investment portfolio. It is comparable to the use of beta in academia and research.
How is Alpha measured?
Alpha is measured on a simple decimal fraction (e.g., 0.7 or 1.2). A value that is higher than 1.0 indicates that the investment has more potential for gains than losses and vice versa. An alpha of zero represents an absolute performance track record against that of the market index. Whereas an Alpha with a positive number means the returns are above or excess of the benchmark. However, an Alpha with a negative number means the investment performed below the benchmark index.
There are many ways to measure an investment strategy’s ability to generate an excess return, most are based on the standard deviation of returns or volatility of returns.
Alpha is usually measured as a percentage to express the magnitude of this expected excess return, and you can look up Alpha before your potential investments in various financial instruments. But if you want to see how much an investment could gain rather than lose, you should use Sharpe Ratio or Sortino Ratio.
Is positive Alpha good?
Yes, as mentioned above, a positive Alpha is generally good. This means that the investment or portfolio performed better than the benchmark index.
Most portfolio managers and investors try to generate excess returns or positive Alpha. The reason for this is because if the Alpha is not positive, then the investor may have been better off just investing in the benchmark index.
What is a benchmark index?
A benchmark index is an index used by the investment community as a point of reference for the performance of different stock segments.
Numerous financial indexes track the prices or returns on categories of stocks, bonds, mutual funds, or other types of investment vehicles.
The most well-known and widely used benchmarks are Dow Jones Industrial Average (DJIA), S&P 500 and Nasdaq Composite Indexes.
An index may also refer to a published list showing comparative values at a given time for shares in that particular market. The most highly regarded indices were those compiled by Dow Jones & Company and Standard & Poor’s Corporation (S&P).
Alpha Examples and Risks
What is beta in stocks?
In finance, beta () is a measure of the instantaneous relative volatility of a stock. A beta value less than 1 indicates that the stock is cheap and a beta greater than 1 indicates that the stock is expensive. While other measures of volatility such as standard deviation can be used to measure overall volatility, they are not particularly useful for measuring relative volatility because standard deviation estimates vary with time and with how much information about past price movements has been known.
Beta is expressed as a decimal fraction (e.g., 0.9 or 2), but it can also be measured in percentage terms (e.g., 99% or 6%).or in decibels (e.g., 15 or 10).