Investment word of the day: Alpha — what is it, how is it calculated and why is it crucial for active investing? | Stock Market News
Source: Live Mint
Investment word of the day: Most investors track their investments’ performance to determine whether their strategies are achieving the desired results. Along with aligning with personal financial goals, checking an investment’s performance helps understand its relative performance to the benchmark index. One key measure to check this is alpha.
What is alpha?
Alpha, a technical analysis tool used in the stock market, is denoted by the Greek letter — α. It shows the excess return of an investment relative to a benchmark index.
How is alpha calculated?
Alpha is calculated by comparing the actual returns of an investment to the returns estimated by a benchmark index, taking into account the investment’s beta, which reflects its sensitivity to the market.
How alpha is interpreted?
If alpha is positive, it means that the investment has performed better than the benchmark. A negative alpha shows that the investment has underperformed the benchmark index. A zero alpha highlights that the investment returns are in line with the benchmark index.
Why must investors consider alpha?
“While assessing how well they or their investments performed, investors need to take alpha into consideration. Out of the many ways one can measure performance, alpha indicates the return created from a particular asset or portfolio over and above a chosen benchmark index. This makes it important for underperformers in the market,” according to Siddharth Maurya, Founder & Managing Director of Vibhavangal Anukulakara Private Limited.
“In particular, it is important for active investing where fund managers look for ways to exceed the rates that come from passive index investing. A positive alpha identifies an effective strategy and stock selection, while its negative counterpart does the opposite. Hedge fund investors, along with those investing in alternatives, should evaluate portfolio alpha to decide if the fund’s strategy is adding value or simply mimics the market,” Maurya said.
Alpha is important in evaluating and assessing risk in performance.
“It helps an investor separate the return that is achieved due to market activity from those that are achieved due to intelligent investing. When building a diversified portfolio, investors have to balance alpha with other risk elements such as beta by making sure that high alpha does not come with high risk,” Maurya said.
According to the expert, investors can use alpha during hostile market phases to pinpoint unfortunate assets that are resistant to the general downturn. Although alpha is one of the primary images for those people interested in beating the market, it is prudent to constantly examine other financial measures alongside it to hedge against risk.
Disclaimer: This story is for educational purposes only. The views and recommendations above are those of individual analysts or broking companies, not Mint. We advise investors to check with certified experts before making any investment decisions.
