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The Alpha of a stock is another important investing metric that stock investors need to know about. In this article, we look at what it is and why investors need to know it.
What is the alpha of a stock?
Alpha, also known as the Jensen’s alpha (after the famous American economist who devised the concept and remains a prominant academic more than 5 decades on) or the excess return, is a measure used to evaluate the performance of an investment compared to its benchmark index. It is often considered one of the most important metrics in stock investing.
In simple terms, this metric measures how much an investment has outperformed (or underperformed) its expected return based on its level of risk. This means that an investment with a positive alpha indicates that it has achieved higher returns than expected given its level of risk, while an investment with a negative alpha has underperformed compared to its expected return.
It is more commonly used to measure the performance of portfolios rather than individual stocks. Yes, individual stocks may compare their performance to benchmarks (only when they outperform of course), but they generally won’t use the A-word.
How is it calculated?
Alpha is calculated by subtracting the benchmark index’s return from the actual return of the investment and then adjusting for the investment’s level of systematic risk (also known as beta). The higher the alpha, the better the investment has performed relative to its benchmark index. It is important to note that alpha does not take into account any unsystematic risk (specific risk) of an investment. As a general rule, an alpha of zero suggests an asset earned a return commensurate with the risk. If below zero, then it was too risky given the return. But if above zero, then the investment put outperformed.
Investors often use alpha as a measure of a portfolio manager’s skill in selecting investments and generating returns above the market. As noted above, a positive score can indicate that the portfolio manager has made good investment decisions that have resulted in higher returns than the market average, while a negative score can suggest poor decision-making or an inefficient portfolio.
However, it is also important to note that this metric alone should not be used as the sole factor for evaluating investments. Other metrics such as beta, standard deviation, and Sharpe ratio should also be considered to get a more comprehensive understanding of an investment’s performance and risk. Moreover, alpha may not be relevant for all types of investments, such as passive index funds that aim to track the market’s return rather than outperform it.
And most importantly, investors need to remember that this is a backwards looking metric. As we always hear from fund managers in their product disclosure statements (as they are required to indicate), past performance is not a reliable indicator of future performance.
In conclusion, alpha is a valuable measure in stock investing that provides insight into an investment’s performance relative to its benchmark index and can be used to evaluate a portfolio manager’s performance.
It is important to consider alpha alongside other metrics and to keep in mind its limitations to make informed investment decisions. So, it is vital for investors to understand this metric and how it can be used as a tool for evaluating investments. This knowledge can help investors make more informed decisions about what stock to buy or fund manager portfolio to put their money in and potentially improve their overall investment outcomes.
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