Alpha is a measure of the success of your investment. It calculates how much a stock or fund has outperformed the general market. This follows the principle that when the market rises over time, it adds value to most of the stocks. This is called market return, and is often adjusted with risk. However, there are many stocks which outperform, usually because of higher earnings. Their return is higher than the market. Alpha calculates this difference, by comparing your stock or fund with a benchmark index. It, thus, represents how much value has added or subtracted to total returns.
A stock or fund is thus given a positive or negative alpha value, denoted as a single or double digit value. A positive value denotes outperformance, while the negative alpha means underperformance. A positive alpha of 3.5 means the stock has beat the index by 3.5%. Every investor is thus ‘seeking positive alpha’.
Origin of Alpha
The concept of alpha originated from the introduction of weighted index funds, which attempt to replicate the performance of the entire market and assign an equivalent weight to each area of investment. The development as an investing strategy created a new standard of performance.
Basically, investors began to require portfolio managers of actively traded funds to produce returns that exceeded what investors could expect to make by investing in a passive index fund. Alpha was created as a metric to compare active investments with index investing.
The basic calculation of alpha simply subtracts the total return of an investment from the benchmark returns, over the same period.
However, it is common to use the capital assets pricing model, or CAPM for short, to gain a more detailed insight into a portfolio’s performance. With this calculation, you subtract the risk-free rate of return (ROR) from the expected return, and then subtract the beta to get to the risk premium. You would then multiply this premium by the market (benchmark) return minus the risk-free rate of return. The calculation looks like this:
Alpha = portfolio return – risk-free ROR – beta * (benchmark return – risk-free ROR)
Let’s say that the expected return is 12% after a year, the risk-free rate of return is 10%, the beta is 1.2 and the benchmark is 11%. Your alpha calculation would then be: 12 – 10 – 1.2 x (11 – 10).
This means that the alpha is 0.8%. This positive percentage means the portfolio is outperforming the market. It is worth noting that the alpha of a portfolio is subject to change if the positions become subjected to larger amounts of volatility – causing the beta to change.
Pros of Alpha
Alpha can give fund managers a general idea of how their portfolios are performing against the rest of the market. In trading and investing, alpha can be helpful tool for establishing market entry and exit points.
Cons of Alpha
Using alpha as a method to calculate returns has its limitations – it cannot be used to compare different investment portfolios or asset types, as it is restricted to stock market investments.
There is a lot of debate about the accuracy of alpha as a measurement. According to the efficient market hypothesis (EMH), all securities are properly priced at all times, so it would be impossible to identify and take advantage of mispricing. If EMH is true, there would be no way to ‘beat’ the market, and alpha would not exist.
The answer to the question on “what is alpha in stock market investments” is that it is a technical analysis ratio that tells you how a stock has performed or yielded results in comparison with a benchmark or a market index. The alpha percentage, often represented in plain numbers such as alpha of 4 or 5, or an alpha of -1, is the value by which a stock or portfolio has outperformed or underperformed vis-a-vis the benchmark. A high alpha means a strong stock and a negative alpha could indicate a weak stock.