In investment terms, alpha refers to the excess return of an investment or portfolio relative to a benchmark index, such as the S&P 500, after adjusting for risk. It measures the value a portfolio manager or investment strategy adds beyond what would be expected based on the market’s performance and the investment’s risk level (typically measured by beta).
Key Points:
- Formula: Alpha = Actual Return – Expected Return
- Expected Return is often calculated using the Capital Asset Pricing Model (CAPM):
Expected Return = Risk-Free Rate + Beta × (Market Return – Risk-Free Rate)
- Expected Return is often calculated using the Capital Asset Pricing Model (CAPM):
- Positive Alpha: Indicates the investment outperformed the benchmark, showing skill or superior strategy.
- Negative Alpha: Suggests underperformance compared to the benchmark.
- Zero Alpha: The investment performed as expected given its risk and market conditions.
- Alpha is often expressed as a percentage. For example, an alpha of 2% means the investment outperformed its benchmark by 2%.