Alpha

Alpha is a measure of residual risk of an actively managed investment relative to a market index composed of similar investments.

Alpha

Alpha is a measure of residual risk of an actively managed investment relative to a market index composed of similar investments.


Alpha Calculation

Alpha is generated by regressing the investment's excess return on the benchmark excess return.  The benchmark could be a stock index such as the S&P500.  The beta adjusts for the risk (the slope coefficient). The alpha is the intercept.

Alpha formula:  Stock Return - Beta * Index Return

Alpha formula:  Stock Return - Beta * Index Return

Chart illustrating determination of Alpha

Alpha Interpretation

Alpha signifies how an investment has performed after accounting for the risk it involved.  If Alpha is less than zero then the investment earned too little for its risk.  If Alpha is zero then the investment has earned a return adequate for the risk taken.  If Alpha is greater than zero then the investment has a return in excess of the assumed risk.

As an example, a return of 20% may appear good, the investment can still have a negative alpha if it's involved in an excessively risky position.  Alpha is commonly used to assess active managers' performances.

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