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What is Alpha, and why does it matter?

In investing, the term “alpha” refers to the excess return of an investment relative to a benchmark, such as a market index. An investment that outperforms the benchmark has a positive alpha, while an investment that underperforms has a negative alpha.

For example, if the stock market is returning 8% per year and an investor’s portfolio is returning 10% per year, the investor’s portfolio has an alpha of 2%. This means the portfolio is outperforming the stock market by 2% per year.

Alpha can be considered a measure of a portfolio manager’s skill. A portfolio manager generating consistently positive alpha is considered skilled, whereas one generating consistently negative alpha is considered less so.

The simplest method to calculate alpha is to subtract the benchmark return from the portfolio return. For instance, if the benchmark has a return of 8% and the portfolio return is 10%, the alpha is calculated as: 10% – 8% = 2%. This implies a positive alpha of 2%.

A more sophisticated approach to calculate alpha uses the Capital Asset Pricing Model (CAPM) or regression analysis, which consider various factors including the risk of the portfolio, represented by the beta coefficient.

Here is how alpha is calculated using the CAPM model:

Alpha = Portfolio Return – [Risk-Free Rate + Beta * (Market Return – Risk-Free Rate)]

In this equation:

  • The portfolio return is the return achieved by the portfolio.
  • The risk-free rate is the return of a risk-free investment, like a Treasury bond.
  • Beta is a measure of the risk arising from exposure to general market movements.
  • The market return is the return of the entire market.


For example, if the Risk-Free Rate is 2% and the portfolio’s beta is 1, with a Market Return of 8% and a Portfolio Return of 10%, the alpha would be:

Alpha = 10% – [2% + 1 * (8% – 2%)] = 2%

This suggests that the portfolio outperformed the expected return given its level of risk, by 2%.

However, alpha is not the only measure of an investment’s performance. Other factors, such as volatility and risk, should also be considered when evaluating an investment.

Alpha is a useful tool for assessing a portfolio manager’s skill and making more informed investment decisions, but it doesn’t provide a comprehensive view of an investment’s performance or a manager’s skill. Various factors, including risk tolerance, investment goals, and market conditions should always be considered when making investment decisions.

“Truth is the daughter of time, not of authority.” – Francis Bacon

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