What is Jensen's alpha?
Jensen's alpha is a formula used to calculate an investment's risk-adjusted value. Also referred to as Jensen's Performance Index and ex-post alpha, Jensen's alpha aims to determine the abnormal return of a portfolio or security, with 'security' referring to any asset including stocks, bonds and derivatives.
Key takeaways
Jensen's alpha, also called Jensen's Performance Index or ex-post alpha, is a formula that calculates an investment's risk-adjusted value and determines abnormal returns of portfolios or securities.
Introduced in 1968 by financial economist Michael Jensen, the formula helps investors determine whether an asset's average return is acceptable compared to its associated risks.
The formula calculates as Portfolio return minus Risk Free Rate plus Portfolio Beta multiplied by the difference between Market Return and Risk Free Rate.
Evaluating risk-adjusted performance is crucial for investment decisions, as higher-risk investments should generally generate greater expected returns to justify the additional risk taken.
Alpha values can be positive or negative, with higher positive values indicating better-than-expected asset performance and negative values showing worse-than-expected performance.
Where have you heard about Jensen's alpha?
Jensen's alpha was first introduced back in 1968 by the well-known economist Michael Jensen, who specialises in financial economics. Today, the formula is an important tool for investors, allowing them to determine whether an asset's average return is acceptable compared to its risks.
What you need to know about Jensen's alpha.
Generally, the higher an investment's risk, the greater the value is of its expected return; therefore evaluating an investment's risk-adjusted performance is incredibly important whilst making investment decisions. The Jensen's alpha aims to do this and is calculated using a simple formula: Jensen's alpha = Portfolio return - [Risk Free Rate + Portfolio Beta * (Market Return - Risk Free Rate)]. Alpha value can be positive or negative with higher positive values suggesting better asset performance compared to expectations and negative values indicated that the asset performed worse than expected.
Find out more about Jensen's alpha.
Further understand this formula by reading our definition of risk free rate.