While a positive alpha is always more desirable than a negative alpha, beta is not as clear. Risk-averse investors, such as retirees looking for a stable income, are attracted to a lower beta. Risk-tolerant investors looking for higher returns are often willing to invest in higher beta stocks. Alpha is important because the purpose of the investment is to generate a positive return – usually higher than the rate of inflation or the performance of the market as a whole. And while the long-term trend of the market is upward, there are many funds that generate much higher returns than market indices. Investors should consider the level of risk they are willing to take to receive this reward, and one way to measure this is alpha. The base number for the beta is one, which indicates that the price of the stock moves at exactly the same time as the market. A beta below 1 means that the stock is less volatile than the market, while a beta above 1 indicates that its price is more volatile than the market. Alpha is the return on an investment that is progressively higher than that of a benchmark such as the S&P 500 or another appropriate benchmark. Alpha is used as a benchmark when an investor chooses an active investment strategy, meaning they are trying to outperform the market. Alpha is therefore a way to measure the amount of extra juice a good investor can create beyond what a passive investor could easily accomplish with an index fund.
Investors use both alpha and beta ratios to calculate, compare and predict investment returns. Both measures use benchmarks such as the S&P 500 to compare them to specific stocks or portfolios. Let`s calculate the alpha of a mutual fund. We assume the fund`s real return is 20, the risk-free return is 5%, its beta is 1.1 and the benchmark return is 20%. To calculate the alpha of a fund, use the following equation: This formula would calculate the values you wrote in column B or (0.10 – 0.06) – 1.1 (0.09 – 0.06). In this scenario, the alpha resulting from the investment is +0.007; This portfolio outperformed the benchmark by 0.007%. Alpha can also refer to the abnormal performance of a security or portfolio that is higher than what would be predicted by an equilibrium model such as the CAPM. In this case, a CAPM model could aim to estimate returns for investors at different points along an efficient boundary. The CAPM analysis could estimate that a portfolio should gain 10% depending on the risk profile of the portfolio.
If the portfolio actually yields 15%, the alpha of the portfolio would be 5.0 or +5% above what was projected in the CAPM model. For example, let`s say you want to find the alpha of an equity fund relative to the S&P 500 over a year. Keep in mind that just because an asset should be less volatile based on its recent trading history doesn`t mean it will be less volatile in the future. Things can change quickly in the investment world, and often events happen that few people expected. Since beta risk can be isolated by diversifying and covering different risks (associated with different transaction costs), some have suggested that alpha does not really exist, but is simply compensation for taking an unhedged risk that has not been identified or neglected. Alpha is a measure of an investment`s performance against an appropriate benchmark, such as the S&P 500. An alpha of one (the underlying asset is zero) shows that the return on investment has exceeded the overall market average by 1% over a period of time. A negative alpha number reflects an investment that underperforms the market average. If beta is 0, the investment and the market have no correlation.
When beta is negative, the investment is inversely correlated with the market, meaning it tends to rise when the market goes down, and vice versa. Active portfolio managers seek to generate alpha in diversified portfolios, with diversification designed to eliminate unsystematic risk. Because alpha represents a portfolio`s performance relative to a benchmark, it is often thought of as the value that a portfolio manager adds or subtracts from a fund`s performance.