Alpha in the Stock Market
Alpha is a measure used to understand the performance of a stock compared to its benchmark index. The measure eliminates the volatility in the market to depict the true performance of the stock.
Alpha can be a positive or a negative value indicating the stock either outperformed (positive alpha) or underperformed (negative alpha) compared to the benchmark index. Alpha represents the percentage of how a stock is performing. For example, an Alpha is 2 (+2) represents the stock outperformed the benchmark index by 2%. The concept of Alpha remains the same in a portfolio of investments as a whole rather than one particular stock. For example, if a fund manager demonstrates that his investment portfolio has an Alpha value of 5, it means that the portfolio as a whole performs 5% better than the benchmark index. In this case, a few stocks in the portfolio may have a negative Alpha and others may have a positive Alpha. Hence, the portfolio’s overall Alpha is positive, giving you a positive return on your investment.
Before learning to calculate Alpha, let us first understand how the market work. Usually, weights are assigned to particular stocks (in case of a stock market index such as Nifty50) or to particular areas of investment (in case of a portfolio with a fund manager). Hence, highly weighted stocks / investment areas drive the performance of the index / portfolio. Alpha here helps to understand the risk premium (actually return on the stock / investment) compared to the benchmark’s return. It negates the effect of volatility around and provides actual return.
Alpha can be calculated using the Capital Asset Pricing Model (CAPM) formula for portfolio management which goes as follows:
CAPM = Rf + beta x (Rm – Rf)
Alpha = Rp – CAPM
Rf = risk-free rate (usually the rates on FDs or Bonds)
beta = systematic risk of a portfolio (please stay tunes for a detailed article on beta coming next week)
Rm = market return (the benchmark)
Rp = Actual return from the investment/ stock
Limitations of using Alpha
- Alpha is best when used in the stock market than in a portfolio of investments
- If used for portfolio or funds, then the comparison must be made between two similar kinds of funds (for example, large cap funds must be compared with other large cap funds and not mid-cap funds)
- Choosing the right benchmark is important. For example, your stock is from the Banking sector then which benchmark will you choose? Nifty Bank Index or Nifty50? It depends. I recommend calculating Alpha for as many benchmarks possible. Then compare the historical performances and experiment what works best for you.
Many use Alpha and Beta together to gauge their returns. While Alpha eliminates volatility, Beta refers to the risk that comes with volatility. Both are important to understand your returns and make a decision.
Stay tuned for another article next week on Beta.
Disclaimer: These articles are intended towards novice audience trying to understand the market with little to no knowledge about the same. The purpose is educational and must not be considered as a tip of any sort. Always make your financial decisions based on expert's personal advice to you. Also, do not forget to do your background research and not fall prey to any kind of fraud or manipulation.