Alpha is a measure of highest return on an investment with minimum risk compared to its benchmark. It is the excess return as compared to the expected return. When a stock outperforms or underperform and gives a return higher or lower than the market, alpha will calculate this difference of return to a benchmark index and sum of this positive or negative return to the total return on a portfolio consisting of number of stocks. Alpha is also a measure of performance of a Portfolio Manager in terms of his investment decisions. Zero alpha will indicate that the Portfolio is managed by the Portfolio Manager in a better way and he has not lost or added any value to it. Positive alpha means stock has outperformed and negative means stock has underperformed.
Calculation of Alpha:
Alpha is expressed in terms of annualised return percentage. Its calculation consists of 2 parts:
- Expected return of stocks
- Actual return of stocks
Assume that the expected return of a portfolio in next 1 year is 5% and the actual return at the end of the 1 year is 8%. Then here Alpha is 8% – 5% = 3%.
As per the Capital Asset Pricing Model (CAPM) formula,
r = Rf + Beta * (Rm – Rf) + Alpha => Alpha = r – Rf – Beta * (Rm – Rf)
- r = Return of the Portfolio
- Rf = Risk free rate of return
- Rm = Market Return
- Beta = Systematic Risk of the portfolio (Relative price volatility of portfolio with respect to overall market price)
A company ABC has given an actual return of 6% at the end of the year as compared to the benchmark index which was up to 5% during the same period. Assume the beta was +1.6. Beta greater than 1 means that security’s price is theoretically more volatile than market. Here its 60% more volatile. The expected return of the stock should have been 8% (5% + 60% of 5%) for holding stock with risk of higher volatility. But here the actual return is 6% which is 8-6=2% less than the expected return. Alpha is -2 here and this investment decision is a bad decision.
Two portfolios having same systematic risk beta can give different returns based on their alpha values. Investment decisions based on alpha value can be beneficial when the portfolio contains assets of the same asset class such as equities or stocks or fixed income bond etc as these assets will behave similarly in the market due to various events which influence the movement of market. Investors will always prefer a high alpha and low beta portfolio for investment. Investors with aggressive decision strategy will even invest in high alpha and high beta portfolio to cash is the price difference arising due to volatility of prices.