Alpha in Stock Market
If you are well-versed in the stock market, you must have heard of the term “Alpha”. It is one of the key ratios used to evaluate the performance of individual stocks or an investment portfolio in the share market. In finance, Alpha value helps to gauge if a strategy or portfolio manager has managed to beat the market return over a period of time.
It is primarily used to track the active return generated by an investment against the benchmark.
Alpha Value
These values in the stock market can be both positive and negative basis the performance of the underlying securities. A positive alpha denotes that a specific asset or portfolio has performed better than the benchmark; a negative alpha means that lower returns has been generated compared to the benchmark index. It can be quoted in the percentage form or numerical form.
Additional Read: Types of Stock Trading
Technical Analysis Tools
Alpha is a crucial technical analysis tool that investors use to gauge the performance of an investment. Modern portfolio theory uses this frequently along with the Sharpe ratio, beta, R-squared and standard deviation.
Jensen’s Alpha
It denotes the variation in returns generated by an investment compared to the overall market. It is a risk-adjusted performance measure that takes the average return on a portfolio or investment, above or below the one predicted by the CAPM, given the portfolio’s or investment’s beta & the average market return.
Limitations
Alpha value does come with some limitations that an investor should consider.
Different kinds of funds are one of its major limitations. Some investors use the ratio to compare various types of portfolios like the ones that invest in different asset classes which can lead to misleading numbers. The diverse nature of the various funds affects it.
Another point of consideration for investors is choosing a benchmark index. Alpha values are usually calculated and compared to a benchmark that’s considered appropriate for the portfolio. Investors should select a relevant benchmark.