What Is Alpha?

By Author: Jamie Hanson
Total Articles: 3495
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If you are involved in your investments then you need to know what Alpha is and how it can help you manage risk. Beta, R Squared, and the Standard Deviation allow investors to measure the risk that volatility in the market creates. However, they do not allow an investor to determine how any additional risk taken paid off outside of volatility. That's where alpha comes into play because it allows an investor to determine if a fund performed better, worse, or on target with its benchmark. Beta must be used to calculate alpha and it allows for investors to see whether the returns were better than the market when the same amount of risk was in play.

When Alpha is 2 it means it was 2% above its benchmark. If the Alpha is -2 it means the fund underperformed the benchmark by -2%. When additional risk is taken and it results in a negative alpha it shows that the risk did not pay off.

Of course, there are four different indicators that should be used to determine whether a fund or investment is growing or not. Keep in mind, too, that you may find several alpha numbers for the same investment or fund. If they are considerably ...
... different the easiest way to determine which one to count on is to look at the R Squared number. The calculation with the highest R Squared number is the most accurate. The reason why is because the closer the R Squared number is to 100 the more accurate the beta number will be and ultimately the alpha number.

There are books upon books written on statistical measures like standard deviation, R Squared, beta, and alpha, however you now have the basic information you need to determine whether or not a certain fund specific risk that was taken paid off or not. These figures are certainly not easy to calculate and a simple error could give you wrong information. Before applying these terms to your investments make sure you understand them well and know how to apply them. Also, don't focus simply on these types of calculations if you are interested in investing in mutual funds because there are other factors that should be taken into consideration other than volatility.

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.