Constructing a high alpha portfolio is the goal for hedge fund managers. Alpha measures how much a stock, fund, or asset outperforms or underperforms the market or benchmark.
Are you seeking Alpha? How to use Alpha in stocks, improve your investing, and implement your own alpha calculator in Excel.
What is Alpha in stocks?
Alpha is an important concept in stock investing. It measures how much a particular stock or mutual fund outperforms or underperforms the market while also considering risk and volatility.
What does Alpha mean in stocks?
Alpha measures the risk-adjusted performance of a particular stock or mutual fund. In other words, it considers the volatility of a security’s returns relative to the market. This makes Alpha a more accurate measure of investment performance than simple returns alone.
There are a few ways to calculate Alpha: one is to use historical data to track how a stock or mutual fund has performed relative to the market over time. Another way is to use Beta, which measures a security’s volatility relative to the market. Finally, you can also calculate Alpha using regression analysis.
Key Takeaways: Alpha in Stocks
- Alpha measures how much an asset has outperformed a benchmark
- Alpha can be a simple calculation or can factor in risk-adjusted returns
- Alpha considers risk and Beta (volatility)
- Alpha can be used to measure the performance of entire portfolios
How to use Alpha for stock picking
Alpha can be used in two ways: to help investors choose stocks or mutual funds that have the potential to outperform the market and to help investors assess how well their current investments are performing.
Generally, stocks or mutual funds with high alpha are considered riskier but also have the potential for higher returns. Investors should exercise caution when investing in securities with high alphas, as they can be more volatile than the market as a whole.
How to calculate risk-adjusted Alpha in stocks?
Alpha is a measure of how well a particular stock or mutual fund does compare to the market. You can calculate it in different ways, but usually, you use historical data or Beta. Alpha can help you choose stocks that have the potential to do better than the market, and it can also help you see how well your current investments are doing.
What is a good alpha for a stock?
A good alpha for a stock is anything above zero. This means that the stock has outperformed its benchmark. Ideally, you want to find stocks with alphas that are as high as possible since this indicates that they have the potential to generate higher returns than the market average.
A stock with an alpha of 1 or higher is generally considered a good investment. This means that the stock has outperformed the market by at least 1% over a period of time.
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How to calculate the Alpha of a stock
There are two ways to calculate Alpha:
The simplest way to calculate Alpha is to subtract the market return from the stock’s or mutual fund’s return. For example, if the market returned 12% last year and your stock portfolio only returned 11%, your Alpha would be -1%.
The second way to calculate Alpha is to compare the risk-adjusted returns of a stock or mutual fund to its benchmark index. Risk-adjusted returns consider factors such as volatility, which can impact a security’s performance. A higher risk-adjusted return indicates that a security has outperformed its benchmark index after considering these risk factors.
What is a risk-adjusted return?
A risk-adjusted return is a measure of a security’s performance that considers the amount of risk associated with that security. It is used to compare the risk-adjusted returns of different securities to see which one performed better after accounting for the amount of risk they each carried.
The risk-free rate of return
The risk-free rate of return is typically taken to be the return of US treasuries. US 10-year treasury bonds are considered a risk-free investment, and they currently yield 4% per year. So if you are calculating any risk-adjusted return, you need to subtract 4% from the assets return.
There are two ways to calculate risk-adjusted returns:
The Sharpe Ratio
One common method is to use the Sharpe ratio, which measures an investment’s return minus the risk-free return rate divided by the standard deviation of returns.
Alpha measures the excess return of a security relative to its benchmark index after adjusting for Beta, which is a measure of volatility. A higher alpha indicates that a security has outperformed its benchmark index after considering these risk factors.
How to use Alpha for investing?
There are several ways to use Alpha when making investment decisions. One way is to use it as a measure of risk-adjusted returns. This can help you identify stocks or mutual funds that have the potential to generate higher returns than their benchmark indexes after taking into account risk factors.
Another way to use Alpha is to compare the performance of different stocks or mutual funds within the same asset class. For example, if you compare two stock portfolios, the one with the higher Alpha is likely to be the better performer.
Finally, you can use Alpha as part of your overall investment strategy. For example, you might allocate a certain percentage of your portfolio to stocks or mutual funds with high Alpha to generate higher returns.
Generally, a stock or mutual fund with a high alpha has the potential for higher returns. Investors should exercise caution when investing in securities with high alphas, as they can be more volatile than the market as a whole.
How to calculate the Alpha of a stock in Excel
To calculate the Alpha of a stock in Excel, you can use the following formula:
Alpha = ((Portfolio Return% – Risk Free Rate of Return%) – Beta * (Benchmark Return% – Risk Free Rate of Return%)
|1||Alpha = 8.8%||=SUM((B2-B4)-B3*(B5-B4))|
|4||Risk-Free Rate of Return (10-Year Treasury Yield)||8%|
Excel Formula & Calculation Table – Copy Highlighted Cells into Excel & It Works
Example: Calculating Alpha for an ETF or Portfolio
This example shows how to calculate the Alpha for the Invesco QQQ Nasdaq 100 ETF using accurate numbers for Nov. 2022.
|2||Portfolio/ETF Return (Invesco QQQ 3-Year Annual)||13%|
|3||Beta QQQ (3 Year)||1.07|
|4||Risk-Free Rate of Return (10-Year Treasury Yield)||4%|
|5||Benchmark 3-Year Return (S&P500)||9%|
Excel Formula & Calculation Table for QQQ – Copy & Paste Highlighted Cells into Excel
Here you can see that investing in the Invesco QQQ Nasdaq 100 index tracking ETF yields an expected yearly Alpha of 3.7% above the S&P 500 returns.
Example: Calculating Alpha for Apple Inc.
This example shows how to calculate the Alpha for Apple Inc. stock using accurate numbers for Nov. 2022.
|2||Stock Return (Apple 3-Year Annual)||34%|
|3||Beta AAPL (3 Year)||1.17|
|4||Risk-Free Rate of Return (10-Year Treasury Yield)||4%|
|5||Benchmark 3-Year Return (S&P500)||9%|
Excel Formula & Calculation Table for AAPL – Copy & Paste Highlighted Cells into Excel
Here you can see Apple Inc. has an incredibly high alpha of 24.2%. This is because Apple’s stock price increased 34% per year with a Beta of 1.17, compared to the 9% of the S&P 500.
Alpha vs. Beta in stock investing
Alpha and Beta are two important measures that investors use to assess a stock’s risk. Alpha measures how a particular stock or mutual fund compares to the market, while Beta measures how much a security moves in relation to the market.
When it comes to Alpha and Beta, there are a few things to keep in mind:
- Alpha is always positive, while Beta can be positive or negative.
- Alpha reflects the possibility of high stock price performance, while Beta reflects the volatility of a security.
- Alpha is used to calculate risk-adjusted returns, while Beta is not.
- Beta is more popular than Alpha because it is easier to calculate.
- Alpha should not be used as the only measure of a security’s risk or volatility.
- Alpha and Beta are important indicators for investors to consider when making investment decisions.
- Most stock software contains Beta calculations but not Alpha.
In summary, Alpha measures how well a security performs compared to the market. Beta measures how volatile a security is relative to the market. Both Alpha and Beta are important factors to consider when making investment decisions.
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Why do investors seek Alpha?
Investors seek Alpha to generate higher returns than the market as a whole. Alpha is a measure of how well a security performs compared to the market, so investors who find stocks or mutual funds with high Alpha can expect to see better-than-average returns.
Additionally, Alpha can be used to measure risk-adjusted returns, which can help investors identify securities that have the potential to generate higher returns than their benchmark indexes.
In conclusion, Alpha is an important concept that all investors should be aware of. By understanding what it is and how to use it, Alpha can improve your investment decisions and portfolio performance!
Thanks for reading! We hope this article provided you with a better understanding of what Alpha is and how you can use it in your investment portfolio.