What’s the first thing that comes to mind when you think about which stock to invest in?

According to science (probably), for most people, this would be “which stock will have the highest returns?” And this is natural for any investor—but how can anyone navigate through the endless sea of possible investments to find the best ones?

One of the ways to narrow down your list of choices is a measure called alpha. This coefficient can be quickly calculated for any investment and it can tell us by what margin an asset is outperforming—or underperforming—the markets.

In a world where volatility is creating traps for seemingly good investments, investors need to have as many tools at their disposal to tell strong and safe investments from potential trading disasters. As alpha compares the performance of any asset to the markets, it is a much more accurate representation of long-term performance than yearly averages.

As such, alpha is used by professionals to compare stocks and to determine the true performance of investment funds by calculating how much they are beating the markets, if at all. In this article, we can cover exactly how alpha can be used as a powerful analysis tool, how it is calculated, and what inherent risks you need to be aware of before trusting alpha with your stock and fund picks.

Alpha Defined

Alpha is a number used to quantify how well an asset is performing compared to the S&P 500 or some other relevant index. However, alpha is mostly used to compare portfolios to major stock indices, and measure their performance that way—investment managers often brag about their fund having a high alpha, and this is why.

If an asset or portfolio we compare to the S&P 500 has an alpha of 5, that means it outperformed the index by 5%. And if that were -5, it would mean that it underperformed—generally, the higher the alpha of your portfolio, the better.

Now, alpha can be used to compare investments using any major benchmark, not just the S&P 500, and it gives us an idea about the systematic risk surrounding an investment. It is used together with beta—another important Greek letter—which tells us how volatile an asset is compared to the markets at large.

Understanding Alpha in the Stock Market

So far, alpha seems pretty handy as an analysis tool—it gives us a clear idea of which investments can outperform major indices and by how much. However, alpha doesn’t paint a full picture as it just takes systematic risk into account while unsystematic risk is completely neglected.

Essentially, in this case, systematic risk is the market-wide level of risk that is based on historic price data and not much else. On the other hand, unsystematic risk includes every possible risk factor that’s specific to an asset or an industry—and this is where the bulk of any stock analysis is focused on.

So, because it completely ignores unsystematic risk, alpha cannot be used as a lone research tool. However, once we’ve done our fundamental analysis on a few similar stocks, we can compare them against an index using alpha to determine which is the likeliest one to turn a good profit based on past performance.

But what if we’re not looking at a couple of stocks, but an entire portfolio? Then alpha is a bit handier—namely, fund managers like to diversify their portfolios because it eliminates systematic risk and they use alpha to track their progress toward greater diversification.

If we apply alpha to an entire portfolio of well-researched investments, and then aim to generate a greater alpha by rebalancing our positions, that can help us optimize our holdings. This is an oversimplification, but generally, the higher the alpha, the better the portfolio (in theory)—and that’s why this Greek can be a great tool for helping investors measure their performance year after year.

So What Exactly Does a High Alpha Mean?

An alpha higher than 1 is already a high alpha—it means that an investment is outperforming the markets by 1%. However, with stellar returns comes a higher alpha—so what number should we aim for in our portfolios?

That completely depends on the investor and their investment goals—and not everyone wants an alpha of 20+ necessarily. This is because alpha doesn’t tell us how risky something is—just how well it performed historically (and what happened before mightn’t happen again).

For example, a portfolio full of ‘safe’ assets like bonds and gold will probably have a very low alpha when compared to a stock market index. But, a portfolio like that is very resilient to crashes and recessions, so a high alpha is sacrificed for the sake of security, which is exactly what some investors want.

In this case, optimizing the portfolio using bonds and gold as benchmarks makes a lot more sense as it allows the investor to make sure that the safe, conservative assets they do have are the best ones out there. Alpha can be used to pull out the weeds, so to speak.

Now, if we’re browsing through funds on our investment apps, a high alpha is very important. In general, funds strive to outperform major indices—as such, alpha can be viewed as a measure of their overall ability. A fund with a high alpha means that the fund manager is up to snuff.

 All in all, before concluding that something has a good or bad alpha, we must make sure that we know what our financial goals are and that we use a proper benchmark. For instance, if a bond ETF is compared with the Dow Jones Industrial Average during a period of economic prosperity, its alpha will certainly seem low, even if this is the single best bond ETF in the world.

How to Calculate Alpha

Alpha, a.k.a. Jensen’s measure has a fairly simple formula, but unfortunately, a few of the elements of the formula have their own formulae that need to be solved first—it is like a fairly cooperative Lernaean Hydra whose heads don’t grow back. Here is how it looks:

Now, let’s unpack this. Realized return of portfolio (Rp) is fairly straightforward—it is just the returns (expressed in a percentage) that your portfolio made in a period in the past. 3 years is a commonly used time frame but this depends on how forward-looking your strategy is.

Market return (Rm) is simply the return that your index of choice had in that same period. If we’re calculating the alpha of a stock portfolio, then a major stock index should give us the Rm.

The risk-free rate (Rf) is a tiny bit more complicated. To get this number, we must take the yield of a fresh Treasury bond and subtract the rate of inflation from it.

This gives us the real return rate of a Treasury bond, which is considered a zero-risk investment because its payout is guaranteed by the U.S. government. And finally, we have beta—another Greek which gives us an idea about our portfolio’s volatility, which also only looks at systematic risk.

Now, all these formulae must seem like a hassle, but as with almost everything in the 21st century, computers can do it for us. The charting software that comes for free with any of the major stock brokerage platforms has built-in indicators that can show us any asset’s alpha and beta.

But, to find out the specific alpha for your unique portfolio, you need to either calculate it or set up a simple algorithm that does this automatically in MS Excel or similar software.

What’s the Capital Asset Pricing Model (CAPM)?

All assets we can ever hold are always exposed to systematic risk—the forces that universally apply to the entire market. These are things like interest rates, inflation rates, wars, pandemics, and all events that touch just about everything when they occur.

And since systematic risk is a theme here, we need a handy formula to help us determine which stocks are worth the risk they carry in potential returns. As with many investment risk coefficients, the CAPM is based on Modern Portfolio Theory which has been in dispute ever since the Nobel Prize laureate, Harry P. Markowitz published the theory.

Nonetheless, the CAPM can be useful because it calculates the expected returns of an asset while taking risk into account and adjusting the expected return accordingly. This model is a bit more complex than alpha, but it can be used in conjunction with the no. 1 Greek to deliver a broader picture of a stock’s potential profitability.

Here is how CAPM works:

The expected return of a security is generated by adding the risk-free rate—usually, the guaranteed return one can gain from a 10-year Treasury bond—and the equity market premium of said asset which is multiplied by the asset’s volatility coefficient (beta). In short, what this tells us is how high a stock is likely to jump or fall against the markets in a given period.

On its own, the CAPM is a way of predicting how high an asset’s expected returns are compared to something that can be considered a perfectly safe investment—like a Treasury bond. All in all, it is another metric that can help us pinpoint which future outcome is the most likely based on the historical data we have—provided that markets act ‘efficiently’ and not like a hectic mess that sent traders into chaos in early 2022.

Example of Using Alpha to Compare Funds

That was quite enough theory and formulae, so let’s see exactly how it looks when we use alpha to compare the performance of investment funds. Let’s take the NASDAQ-100 Technology Sector (NDXT) index as a benchmark and compare a few tech-focused mutual funds and ETFs—note that NDXT achieved a 97% return from the beginning of 2018 to the end of 2020 and a 27% return in 2021.

As we can see, all exchange traded funds (ETFs) except one outperformed the NDXT index, but all of them have a positive alpha. Sure, alpha indicates how likely an asset is to outperform the markets but it also takes into account its level of risk.

In the case of FITE, the alpha of 1.42 tells us that this ETF has produced larger returns than expected for its risk level—and this is where we start to see flaws in the logic behind alpha.

Alpha Can Be Misleading

FITE is an ETF that only invests in cutting-edge military and cybersecurity technology. As such it is in a niche technology sector that might not grow like Mickey’s magic beans, but is relatively safe—these technologies are always crucial, are always in demand because of governments, and are likely to remain so in the unstable geopolitical landscape that was further destabilized with the conflict in Ukraine. However, iPhones are in greater demand, and VGT has a huge stake in Apple, so…

So what happened here is that FITE performed poorly compared to the tech index, as well as the other ETFs on this list, even though it has the highest alpha. This is because the ETF is fairly niche compared to the rest and we can’t find a perfect benchmark to compare it to.

This is a problem with alpha—as perfect a benchmark as possible is needed to properly compare funds. Moreover, alpha isn’t a crystal ball—it can only tell us the probability of something and it can be very wrong. In this case, the ETF with the lowest alpha was the best performer and vice-versa.

This example tells us a number of things: Firstly, that alpha is very sensitive and requires very similar funds for comparison. Also, alpha cannot consider the million things that can happen to an industry in the future, and finally, alpha simply tells you that something is probable based on past performance but that doesn’t mean it will happen.

As we now know, the NDXT index grew by 27% in 2021 so any prediction based on these funds’ alpha measures would have driven an investor into giving priority to weaker funds. All in all, alpha is used by professional investors, but for making solid predictions, a much broader and deeper analysis is required.

Why is Alpha Important for the Stock Market?

Just like Santa, Wall Street has a list of its own—this tells us who has been a good kid this year, so to speak. The worth of all sorts of funds can be measured using alpha, and this is because most funds generally aim to outperform an index. This is how the list was made.

In a way, an alpha of an index fund will tell us how good the manager is and will help us determine where to invest our money. Moreover, looking at the alpha of a fund is much more insightful than simply looking at overall returns because when the markets are booming, every fund manager looks like a high-performance wizard, and that’s simply not the case—in times of crisis, many funds show indecision and bad returns.

The same logic works in bear markets: If the markets are in a huge recession, every index fund manager will seem like a loser. But, some managers will still outperform the markets while some will not—and the difference that makes for the inventor’s end-of-year returns is huge.

That is why alpha is a very important measurement in the stock market. It gives us an idea of which manager is doing well and how much—and specific market conditions in that period won’t skew our perception of said fund’s performance. Because of this, alpha ratings can bring a lot of attention and capital to a fund, and funds like this are often worth investing in.

What to Consider Before Using Alpha

The first consideration we need to make before we start using alpha to tell what is worth investing in and what isn’t is systematic risk. Alpha doesn’t take unsystematic risk into account at all, which means fundamental analysis, technical analysis, and important news are out of the picture. But, if Elon Musk can make Dogecoin pump by buying a stake in Twitter, that is crucial info that cannot be replaced by a formula.

Needless to say, everything mentioned above is very important, so we can rest assured that alpha won’t give us anything close to a full picture about anything we apply it to. Rather, it makes much more sense to run a thorough analysis on a bunch of assets, and then simply view alpha as the icing on the cake, rather than the dough.

Moreover, alpha uses historical data that might indicate a pattern, but this cannot help us predict the future. For instance, the COVID-19 pandemic crashed the market and then did wonders for cannabis stocks, healthcare, telecommunications, and food/grocery delivery companies while completely decimating airlines and oil companies—none of which was predictable with math.

If we made a prediction based on alpha before the pandemic hit, we would’ve made a huge mistake. Like Orpheus, although alpha has its merits, it is a very narrow-minded Greek that simply cannot bring any stock out of Hades by itself.

Moreover, there are a few more popular risk ratio coefficients that play a similar role to alpha. Some of these include beta (which should be used in conjunction with alpha), the Sharpe ratio, R-squared, and standard deviation.

And finally, what is probably the most important thing to note when using alpha, is to always use a relevant benchmark—the asset we are looking at needs to be compared to a relevant index, otherwise, its alpha might be completely useless.

For example, if we compare ARKK Innovation, the super-advanced tech ETF with the S&P 500, we will see that ARKK outperforms the markets by a huge margin and is, therefore, a much more lucrative investment. However, if we compare it to the NASDAQ-100 Technology Sector Index, a fellow tech industry index, it doesn’t seem as impressive.

Furthermore, the ETF was one of the worst-performing U.S. equity funds in Q1 2022, so the high alpha it had generated before, could not in any way predict the troubles that ARKK fell into later. However, considering that this was the case with most growth-focused funds, these losses don’t say that much about ARKK—but we should walk away from this a bit more cautious about using alpha.

How to Use Alpha and Beta to Your Advantage

In the end, everyone gets into investing to make money, and to do this, we need to know how to use all this fancy theory in practice. So, here is how alpha can be used to improve your everyday investment journey.

Let’s take a bunch of tech stocks and ask ourselves a question: Which one of these will perform the best in the next few years and why?

We can look at the alphas of each of these stocks simply to eliminate the really weak performers straight away and narrow our list. Then, we should ideally narrow our list even more by conducting serious fundamental analysis.

Now that we probably know why these stocks are growing and we have an idea of why they might rise in the future, we can narrow our list even further, keeping only the best 5 or 10. Then, once we’re satisfied with our fundamental analysis. we can find the alpha for each of these stocks—but we should use a relevant index like the NASDAQ-100 Technology Sector Index.

Now we can see which of these stocks are the best performers, and because of our fundamental analysis, we know why as well. We can use this knowledge as well as the alphas of these stocks to narrow our list even further and isolate the best 3 to 5 companies in the sector. However, we must look at systemic risk as well as the modern stock market is a volatile one—and that’s where beta comes in.

Adding Beta to the Mix

However, a portfolio that consists of tech stocks alone is not very balanced—we want our investments to thrive during a recession as well, which means we need a very diverse bunch of assets. Stocks do well during bull markets, but if an economic crisis hits, the top performers will likely be fixed-income securities and gold.

This is where beta becomes very important as it tells us how differently each of our assets acts to the stock market. For example, beta can tell us if an asset is positively or negatively correlated with an index, and also, if it is completely uncorrelated (this is then the beta is 0).

If we can have a mix of assets that fits into these 3 categories, our portfolio will be much safer and it will have money-making assets in all market scenarios. As great as it would be to have 5 Michael Jordans on a basketball team, we must remember that Dennis Rodman’s rebounds and assists are a big part of what made Jordan such a brilliant scorer, and a portfolio should work like that as well—as a team with a specialist for every role.

All in all, if we split a portfolio into a part with a low, neutral, and high beta, and then optimize all 3 elements using thorough analysis and alpha, we can end up with something that resembles a versatile, efficient, and coordinated NBA team. Many modern portfolios like the dragon portfolio use a similar template and are showing great results for it while outperforming the seemingly-outdated 60/40 portfolio.

However, beware of assets that have a very high alpha and beta. Although this might seem like a good investment, it is very likely a double-edged sword. An asset that works extremely well in a bull market might do exceptionally badly in a bear market, so it is often best to avoid such extremes just to be on the safe side.

Pros and Cons of Chasing Alpha

The benefits of using alpha are that we can judge the efficiency of funds very quickly and that we can easily compare them to find the best possible investment. Moreover, alpha can be used to compare different stocks and other individual assets, but that only makes sense after we’ve understood those investments through fundamental analysis.

On the other hand, alpha is a very limited tool that doesn’t consider unsystematic risk, which means it doesn’t consider any factors that might affect an asset outside of limited historical price data. As such, investors who get too mesmerized by a fund’s high alpha might miss the fundamentals—like what happened when a fund called OCP committed securities fraud estimated at $11 million.

However, when alpha is used after thorough analysis, and we use a proper benchmark, it is a fantastic tool for comparing potential investments, and it is a great way of measuring the performance of our portfolio while considering the market average at all times.

But beware—funds and investment gurus like to advertise their success by claiming their portfolios have a high alpha. However, this data can be skewed in a million different ways: the benchmark index they used, as well as the specific time frame, can make a weak fund look fantastic on paper, so be careful before blindly trusting in other people’s alphas (or the rest of the alphabet for that matter).

Moreover, active funds tend to underperform during high market pressures, so their overall past performance likely won’t be an indicator of future success in a recessive market. As handy as alpha might be, it can lead to a plethora of wrong conclusions if not used carefully.

Conclusion

To any new investor, the Greeks often seem like quantum rocket science but after they’ve been demystified, they can become a very handy tool that can be used alongside any stock analysis method. Alpha in particular is great for comparing funds and narrowing down lists of potential investments quickly.

However, alpha is only the first letter of the alphabet, and like writing, investing doesn’t work very well without all of them—nor does it work without fundamental analysis, and following relevant news. All in all, alpha is just something to help you narrow down your search for good assets, rather than a metric that can reliably tell you what is better or worse.

Understanding Alpha: FAQs

What is Alpha Excess Return?

A positive alpha is considered an excess return on the benchmark that is used as a comparison. For example, if we’re calculating the alpha of a stock and we use the S&P 500 as a benchmark, an alpha of 5 means that the stock in question did roughly 5% better than the S&P in that given period.

What Happens When Alpha Increases?

When the alpha of an asset or portfolio increases, it means that its performance improved when compared to the market average. An increased alpha is usually a good sign as it bears no negative implications.

What Does Negative Alpha Mean in Stocks?

If a stock has a negative alpha, that means it is performing worse than the benchmark it is being compared to (which is usually an S&P 500 index). For example, an alpha of negative 5 means that the stock in question has performed roughly 5% worse than the markets at large.

Which is a Better Alpha or Beta?

Alpha and beta are two completely different metrics and therefore cannot be compared. Alpha tells us how well an asset or portfolio is performing when compared to a stock market index, whereas beta tells us how correlated an asset is to the stock market and how volatile it is in comparison.

Why Would You Use a Low Alpha?

Low-alpha assets can play a role in a balanced portfolio—these can be assets like bonds and gold that are used to hedge against stock market crashes and to provide growth in recessive periods. Moreover, since alpha only takes systemic risk into account, an asset can be a good investment due to other factors even if its alpha is low at the moment.

How Do You Increase Alpha in a Portfolio?

The alpha of a portfolio can be increased by adding more high-alpha assets. However, doing this without using other forms of analysis to determine the unsystematic risk of the assets in question is very risky.

What’s a Good Alpha?

A positive alpha is considered a good alpha. But in general, the higher it is, the better odds it represents.

This article originally appeared on Tokenist.com and was syndicated by MediaFeed.org

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