One investment strategy is to look for securities with positive alphas, which indicates they may be undervalued. If the stock gained 4%, it would have a positive alpha.Īlpha also refers to an analyst's estimate of a stock's potential to gain value based on the rate at which the company's earnings are growing and other fundamental indicators.įor example, if a stock is assigned an alpha of 1.15, the analyst expects a 15% price increase in a year when stock prices are generally flat. If a security's actual return is higher than its beta, the security has a positive alpha, and if the return is lower it has a negative alpha.įor example, if a stock's beta is 1.5, and its benchmark gained 2%, it would be expected to gain 3% (2% x 1.5 = 0.03, or 3%). Beta measures the security's volatility in relation to its benchmark index. Alpha.Īlpha measures risk-adjusted return, or the actual return an equity security provides in relation to the return you would expect based on its beta. Copyright © 2003 by Houghton Mifflin Company. For example, if a stock performs 3 better than the S&P 500, the alpha of that stock would be 3. Specifically, alpha indicates the percentage below or above a benchmark index the stock achieved, but is represented as a single number. Wall Street Words: An A to Z Guide to Investment Terms for Today's Investor by David L. Alpha measures the return on an investment compared to a market index or benchmark. For example, it may be the intercept in a multifactor model that includes risk factors in addition to the S&P 500. Hence, the alpha is 2% or 200 basis points. The expected excess return given the risk is 2 x 9%=18%. Suppose the beta of the mutual fund is 2.0 (twice as risky as the S&P 500). During the same time the market excess return is 9%. ![]() Example: Suppose the mutual fund has a return of 25%, and the short-term interest rate is 5% (excess return is 20%). The beta adjusts for the risk (the slope coefficient). More appropriately, an alpha is generated by regressing the security or mutual fund's excess return on the benchmark (for example S&P 500) excess return. However, this does not properly adjust for risk. Some refer to the alpha as the difference between the investment return and the benchmark return.
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