In the world of stocks and investments, alpha is a concept from advanced investment statistics that has been pulled into wider use to put a label on an investment concept. You do not need to be a statistical mathematician to use the concept of alpha to improve your stock market results.
Modern Portfolio Theory
Alpha is a statistical measurement out of the investment discipline called Modern Portfolio Theory. MPT is concerned with calculating expected investment returns considering the measurable risk, volatility and the risk-free rate of return. Primarily examining the asset classes such as stocks and bonds as a group, Modern Portfolio Theory formulas use the statistical measurements of standard deviation, R-squared, Sharpe ratio, beta and alpha. Alpha is the measurement of the effect of investment choices compared to the returns of the larger asset class.
Beating the Market
In general terms, alpha in the stock market is a measurement of how the returns of an investment portfolio compare against the overall market or a benchmark on a risk-adjusted basis. Investors know that they can get higher potential returns through riskier investments. Alpha is the measurement of how well an investor or portfolio manager did compared to the market when the risk is factored out. The goal of all investors is to make more money at less risk -- finding more alpha.
Individual Investor Alpha
As an individual investor, you can use the concept of alpha to evaluate your existing and new stock investments. To achieve positive alpha, select stocks with higher potential for gains at comparable or lower risk. This may be accomplished by comparing competitor companies and picking the stock with the best potential. For example, you might compare FedEx and UPS using different profitability and growth metrics such as price to earnings -- P/E -- ratio and earnings growth rates.
Using a Benchmark
To evaluate whether your stock investments are providing positive alpha to your portfolio, select a benchmark against which to compare your results. Your benchmark can be a stock index or exchange traded fund -- ETF -- with risk characteristics similar to your portfolio. For example, if you invest in large-company blue-chip stocks, compare your portfolio returns to an index such as the S&P Dividend Aristocrats. If you invest in technology stocks, compare your results to the NASDAQ 100 stock index -- an index tracking some of the largest U.S. technology companies.
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