Alpha in stocks?

Last Updated: 5 Jul 2022

The aspect of making huge profits is attributed to stocks that perform exceptionally well and beat the overall returns of their peers, sector, or the overall market. But, outperforming the market is not easy. Professional investors have tried numerous stock market strategies to understand what works for them and how they can earn better returns.

One of the most widely used and effective stock market strategies is called Alpha in stocks. In this blog, you will learn about Alpha in stock investing and how to effectively use it to earn hefty profits by beating market returns.

What is Alpha in stocks?

Alpha, written as the greek symbol (α), is a term used to describe a stock market strategy’s capability to outperform a benchmark, such as NIFTY 50, the related sector, or the overall market.

As Alpha in stocks defines stocks providing higher returns, it is sometimes called “excess returns” or “abnormal rate of returns”. The latter name is because it is commonly believed that the markets are efficient in themselves, and it is almost impossible to beat the systematic returns they provide. However, as Alpha in investing allows investors to understand the outperforming process, it becomes an effective measure.

The primary aim of Alpha in stocks is to measure the financial performance of an investment. The investment can be ongoing or potential based on the mindset of the investor. Alpha in investing uses various measures to compare the performance to related market benchmarks.

The baseline value of Alpha in stocks is always zero. Furthermore, if the value of Alpha in stocks is 2, it would mean that the return of the investment instrument outperformed the overall market return average by 2% in a specific time frame. A negative value of Alpha in investing means that the investment returns underperformed compared to the market return average.

Understanding Alpha in stocks

Investors consider Alpha in stocks as one of the most effective of the five popular technical investment risk ratios. As Alpha in stocks is the assessment of a stock outperforming the market, active portfolio managers and investors always look toward generating Alpha in their portfolios.

Alpha in investing always includes diversification within various asset classes to reduce unsystematic risk and the potential of increasing overall returns. As a result, the Alpha value often represents the value that is added or subtracted from a fund’s return because of the strategies used by portfolio managers.

The Alpha in stocks is always used in conjunction with the BETA coefficient. BETA in the share market is an indicator used by investors to assess the risk attached to a specific stock. BETA in the stock market works by assessing the risk of stock with the overall stock market.

Benefits and risks associated with Alpha in the stock market

If a country is doing economically well, the stock market sees a constant uptrend, allowing most companies to generate high returns and resulting in higher index or benchmark points. In such an uptrend, investors use Alpha values to procure shares of small and mid-cap companies that have the potential to outperform the overall returns of the index.

Alpha in stocks is also fairly easy to calculate and analyze. Furthermore, investors can use Alpha in investing to buy individual stocks that create a positive alpha return on the overall portfolio.

A major risk involved in the process of Alpha investing is the volatility factor. As it seeks to generate higher returns than the market, the returns may become inconsistent when compared to the market performance. The idea is based on the principle that generating higher yields than the market is temporary, and the investment instrument will reserve to be in line with the market sooner or later. If this happens, investors can incur losses on their trades.

Things to keep in mind before using Alpha values

Here are some things you should keep in mind before using Alpha in stocks:

• Alpha values do not measure the outperformance of two different types of investment instruments. For example, you can not use Alpha values to measure the outperformance factor being a fixed income benchmark and an equity Exchange Traded Fund. Hence, it should only be used to compare the performance of two similar types of instruments.
• Alpha values are generally associated with Jensen’s Alpha, which considers CAPM (Capital Asset Pricing Model) and other risk-adjusted factors by using BETA and risk-free BETA values.
• While calculating Alpha values, there may be no pre-existing index or benchmark, making it impossible to calculate the Alpha values. In such a case, investors may use other artificial models or algorithms to create a dummy index for comparative analysis and Alpha values calculation.

Final Words

‘Alpha in investing’ is often called the Holy Grail of investing and is popular among investors and big fund houses to outperform the benchmark or the market. Having understood the Alpha values and how it affects the investing mindset of investors, you can now effectively add them to your investment strategies. However, it is also advisable to use the data from Alpha values by combining it with the data of Beta values to get better insights and make informed investing decisions.

Frequently Asked Questions

How do you find the Alpha of a stock?

Here is the formula to calculate the Alpha of a stock: Alpha = R – Rf – beta (Rm-Rf) Here, Rf is the risk-free rate of return, and Rm is the market return based on the benchmark.

Is positive Alpha good?

Yes, a positive Alpha is always a good sign as it means that the returns of investments are outperforming their benchmarks.

What does a high Alpha mean in stocks?

A high Alpha value in stocks means that the stocks are outperforming their respective benchmarks and are rising in price.