Adding Alpha To Your Portfolio

By Author: Jamie Hanson
Total Articles: 3495
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If you are an investor then you know about risk. However, what do you know about managing risk? If so, the terms alpha, beta, and standard deviation are probably common to your vocabulary. If they aren't and you are interested in being a successful investor then it is worth your time to not only learn what these terms mean, but to apply them to your portfolio.

What is Alpha?
To begin with, let's discuss Alpha and why it should be added to your portfolio. Terms like beta and standard deviation focus more about measure volatility imposed risk, but you are probably interested in learning what returns you will gain for taking a particular risk. That's where alpha comes into play. Alpha is what determines how a fund performed and if it out performed its goals. When used in conjunction with beta, alpha will determine if given the same amount of risk a particular fund performed better than the market. The fund's benchmark must be taken into consideration and then measured with the actual returns based on the market, volatility, and other factors. If a fund has an alpha that is negative then that means the fund did not ...
... meet its benchmark and in fact performed worse than the market as related to the additional fund specific risk.

Alpha's Accuracy
Remember, you can't calculate alpha without beta and if the beta is not accurate then the alpha won't be either. That is why it is so important to focus on accuracy when calculating these numbers or otherwise you won't have data that tells you anything realistic. When in search for accuracy you will be happy to know that the higher the R-squared is more likely your results will be accurate. Remember, all alpha is going to tell you is if the extra risk you took for your fund or portfolio as a whole paid off when compared to the market. Since you want to know how your investments are performing it makes complete sense to add a little alpha to your portfolio, in terms of measurement anyway!

Alpha measures a portfolio's return that is in excess of the market return after both are adjusted for risk. Investors seeking higher alpha can consider long short mutual funds as part of their core portfolio holdings.