What is alpha?
What is alpha? Alpha is a risk ratio that describes the return on investment of an asset such as a share or bond in relation to the general market. It uses a benchmark index such as the Standard & Poor’s 500 to compare the past performance of an investment, usually based on the growth of earnings per share.
Key takeaways:
- Alpha is a measure of the return on an investment that is above and beyond what would be expected given its level of risk.
- Alpha is often used as a way to assess the performance of a fund manager or investment strategy relative to a benchmark index.
- A positive alpha indicates that the investment has outperformed its benchmark, while a negative alpha indicates underperformance.
- Alpha is calculated by subtracting the expected return of the investment, based on its level of risk, from its actual return.
Where have you heard about alpha?
Seasoned investors are likely to be familiar with the terms alpha and beta, but they don't tend to crop up in everyday conversation. They’re useful measurements to compare and predict what the return on an asset is likely to be given the level of risk involved.
What you need to know about alpha
Analysts crunch a lot of data on an asset's history and award it an alpha rating. A positive alpha of 1 means the fund or stock has outperformed its benchmark index by 1%. An alpha of 0 means the asset has moved in line with the market, while a negative alpha indicates the investment has underperformed.
For example, if you invest in a stock and it returns 10%, while the S&P 500 earned 5%, you have an alpha rating of 5, which means the investment has done well.
Alpha goes hand in hand with beta, which compares the volatility of a stock or fund with a benchmark index.
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