Alpha

Alpha

Measure of risk-adjusted performance. Some refer to the alpha as the difference between the investment return and the benchmark return. However, this does not properly adjust for risk. More appropriately, an alpha is generated by regressing the security or mutual fund's excess return on the benchmark (for example S&P 500) excess return. The beta adjusts for the risk (the slope coefficient). The alpha is the intercept. Example: Suppose the mutual fund has a return of 25%, and the short-term interest rate is 5% (excess return is 20%). During the same time the market excess return is 9%. Suppose the beta of the mutual fund is 2.0 (twice as risky as the S&P 500). The expected excess return given the risk is 2 x 9%=18%. The actual excess return is 20%. Hence, the alpha is 2% or 200 basis points. Alpha is also known as the Jensen Index. The alpha depends on the benchmark used. For example, it may be the intercept in a multifactor model that includes risk factors in addition to the S&P 500. Related: Risk-adjusted return.

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Alpha

1. The measure of the performance of a portfolio after adjusting for risk. Alpha is calculated by comparing the volatility of the portfolio and comparing it to some benchmark. The alpha is the excess return of the portfolio over the benchmark. It is important to Markowitz portfolio theory and is used as a technical indicator.

2. The excess return that a portfolio makes over and above what the capital asset pricing model estimates.

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alpha

The mathematical estimate of the return on a security when the market return as a whole is zero. Alpha is derived from a in the formula R_i = a + bR_m which measures the return on a security (R_i) for a given return on the market (R_m) where b is beta. See also capital-asset pricing model, characteristic line.

Wall Street Words: An A to Z Guide to Investment Terms for Today's Investor by David L. Scott. Copyright © 2003 by Houghton Mifflin Company. Published by Houghton Mifflin Company. All rights reserved. All rights reserved.

Alpha.

Alpha measures risk-adjusted return, or the actual return an equity security provides in relation to the return you would expect based on its beta. Beta measures the security's volatility in relation to its benchmark index.

If a security's actual return is higher than its beta, the security has a positive alpha, and if the return is lower it has a negative alpha.

For example, if a stock's beta is 1.5, and its benchmark gained 2%, it would be expected to gain 3% (2% x 1.5 = 0.03, or 3%). If the stock gained 4%, it would have a positive alpha.

Alpha also refers to an analyst's estimate of a stock's potential to gain value based on the rate at which the company's earnings are growing and other fundamental indicators.

For example, if a stock is assigned an alpha of 1.15, the analyst expects a 15% price increase in a year when stock prices are generally flat. One investment strategy is to look for securities with positive alphas, which indicates they may be undervalued.

Dictionary of Financial Terms. Copyright © 2008 Lightbulb Press, Inc. All Rights Reserved.