Alpha In Finance

Updated on May 16, 2024
Article byPrakhar Gajendrakar
Edited byAaron Crowe
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Alpha In Finance?

Alpha in finance refers to an unrealistic rate of return. It is a performance metric that gauges improbable returns from an investment. Thus, it is also referred to as the abnormal rate of return. For comparison, it is collated with the benchmark return index.

Alpha in Finance Portfolio Returns

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It is a scenario where the investment has beaten the market or closed it with an edge. The alpha varies for each investment strategy. The value of alpha can be either positive or negative. The concept draws criticism for its inaccuracy, improbability, and application.

Key Takeaways

  • Alpha in finance measures the excessive rate of return from a particular investment strategy. Alpha values are positive when the performance of an investment beats the market benchmark (index).
  • It is not impossible, but it is rare. Recreating similar returns using the strategy that was successful in the past is highly unlikely. Securities are highly volatile and unpredictable; they can fluctuate in response to news, rumors, and trends.
  • Like alpha, there is a beta in finance, which gauges the investment’s volatility. Beta is used for measuring systematic risks associated with a specific investment.

Alpha In Finance Explained

Alpha in finance is the difference between the expected rate of return and the unexpected rate of return. The alpha varies for each investment strategy. Thus, alpha is an index used to determine the highest possible return that can be achieved with minimal risk. Alpha is also known as the Jensen Index.

Alpha in Finance

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For an individual portfolio, alpha is calculated by deducting the expected rate of return from the actual rate of return of the portfolio:

Alpha = Portfolio’s Actual Rate Of Return Of Portfolio – Expected Rate Of Return

The alpha value demonstrates how much worse or better a fund had performed—concerning a benchmark. This variance is then credited to the judgments made by the fund manager.

Alpha is the study of how a certain investment strategy brought an unrealistically positive rate of return. Fund managers study why the particular strategy works. Stock market benchmarks are based on past data and trends. When an investment strategy goes beyond that index rate, and the investor earns over-the-top profits, the difference between the index rate and the real rate of return signifies the alpha value.

Similarly, there is a concept called beta in finance. The beta measures an investment’s volatility. The alpha and beta values are used in conjunction. In statistics, beta is the slope of the line obtained by regressing the returns of stock return and market return. The alpha value can be applied to a simple investment and measure an entire portfolio’s performance.

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Example

Let us look at the alpha in finance example to understand the concept better.

Faye has studied the equity markets very minutely and conducted detailed research. She invests in a couple of promising stocks every year.

In 2022, Faye invested $9000 in a similar stock. Before investing, she studies the particular industry in detail. She invests at the right time. The benchmark returns are at 9%. So technically speaking, Faye could earn a 9% return on her investment of $9000—that is $9810.

But Faye was no ordinary investor. Due to her detailed research, she invested in a stock that yielded a 20% return—$10800.

Let us apply the alpha formula to the given values:

  • Alpha = Actual Rate Of Return Of Portfolio – Expected Rate Of Return
  • Alpha = 20 – 9
  • Alpha = 11%

Faye beat the market by 11%.

Alternatively, the capital assets pricing model (CAPM) can be used to measure a portfolio’s performance:

Alpha = Portfolio Return – Risk-Free ROR – Beta x (Benchmark Return – Risk-Free ROR)

Now, let us assume Faye’s portfolio returned 8%, a risk-free ROR of 11%, and a beta of 1.8% against a benchmark of 9%.

In this scenario, we determine the alpha value of Faye’s portfolio by substituting the values in the formula:

  • Alpha = Portfolio Return – Risk-Free ROR – Beta x (Benchmark Return – Risk-Free ROR)
  • Alpha = 8 – 11 – 1.8 x (9 – 11)
  • Alpha = 0.6

Here, the alpha is 0.6%. Since the value is positive, it reflects that Faye’s portfolio is outperforming the market. But there are cases where alpha values are negative, in which case, the investment is underperforming.

Beta vs Alpha In Finance

The beta and alpha values indicate performance or volatility associated with a portfolio or investment. Now, let us look at beta vs alpha in finance comparisons to distinguish between the two.

  • Alpha gauges the performance of a portfolio or investment. In comparison, the beta measures market volatility. Beta is used for measuring systematic risks associated with a specific investment.
  • Based on alpha, an investor can identify promising investments. In contrast, the beta value help investors understand the volatility associated with each investment.
  • Alpha is denoted by α, beta is denoted by β, and both formulas deduce the market value of securities.
  • The beta measures the sensitivity of stock prices to changes in the market. Thus, Beta measures systematic risks associated with a specific investment.
  • Though beta and alpha are used in conjunction, they measure different aspects of a portfolio.

Limitations

Now, let us look at alpha in finance limitations.

  • The biggest drawback or limitation of alpha is that it is strictly associated with the stock market. It, therefore, cannot be collated with any other portfolio or type of assets.
  • Economists believe that the possibility of coming up with an investment strategy that can beat the market is negligible and hardly probable.
  • The accuracy of the alpha concept is highly debated–security prices are dynamic. They are unpredictable by definition.

Frequently Asked Questions (FAQs)

What is a good alpha?

Any positive alpha value is considered good because it technically means that the investment has performed well, but a high alpha value comes with a higher risk.

What does a negative alpha indicate?

A negative alpha value means that the investment is underperforming in the market. For example, suppose the alpha value is -3; that would mean it underperformed its benchmark by 3%. A zero alpha states that the investment’s performance matched its benchmark.

How to increase the alpha value in finance?

By using futures to control multiple assets with a smaller amount of capital, an investor or fund manager can either invest in risk-free securities or pick individual stocks as per choice to generate positive returns to increase alpha.

This has been a guide to what is Alpha in Finance. Here, we compare it with beta and explain its formula, example, and limitations. You can learn more about finance from the following articles –

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