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.
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.