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Trading and Investment Terms

Alpha

Alpha, also known as "excess return" or "abnormal rate of return," is one of the most widely used measures of risk-adjusted-performance.

Alpha is used to measure performance on a risk-adjusted basis.

 

An alpha of zero means the investment has exactly earned a return adequate for the volatility assumed. 

An alpha over zero means the investment has earned a return that has more than compensated for the volatility risk taken. 

 

An alpha of less than zero means the investment has earned a return that has not compensated for the volatility risk assumed.

 

Alpha is the rate of return that exceeds what was expected or predicted by models like the capital asset pricing model (CAPM).

Consider the CAPM formula:

How Does Alpha Work?

Let's assume A portfolio manager who expects your client's portfolio to return 15% next year. The year goes by and the portfolio returns 16%. In its most basic sense, 

The alpha of the portfolio = 16% - 15% = 1%.

r = Rf + beta * (Rm - Rf ) + alpha

where:

r = the security's or portfolio's return

Rf = the risk-free rate of return

beta = the security's or portfolio's price volatility relative to the overall market

Rm = the market return

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