Alpha in Stocks: Meaning, Importance, Benefits & Risks

When researching the intricacies of the stock market, you may have often come across terms like alpha and beta. They are useful tools for conducting market analysis and can assist you in making informed decisions. 

Let’s see what alpha is in stocks, its values, and how to use it to increase return on investment. 

What is Alpha in Stocks?

Alpha, the Greek symbol (α), is one of the most prevalent technical analysis ratios used in the stock market. You can use it to measure the rate of returns on stock investment and compare it to its benchmark index. It denotes the active returns that you can gain due to the performance of the stock after adjusting the volatility. 

What Are the Values of Alpha?

The values of alpha in the stock market can be positive as well as negative. It totally depends on the underlying security’s performance rate and can be positive if the asset outperforms the market and negative when it underperforms. 

However, for passive index funds, the value of alpha can be zero if the portfolio returns are equal to the fund yields. 

Alpha’s value for stocks is usually represented in percentage, while for mutual funds and other forms of securities, it is denoted in numbers. 

For instance, if a stock has an alpha of +2.3, it means that it has outperformed its benchmark index by 2.3%. Inversely, if an asset has an alpha of -1.5 means, it has a yield that is 1.5% less than benchmark returns. 

What Are the Functions of Alpha?

You can use the value of alpha in the following cases: 

• Capital Asset Pricing Model

Due to the socioeconomic scenario and business cycle, every investment in the stock market comes with an inherent set of risks. To reduce the probability of losses due to these uncertain fluctuations, an assessment needs to be conducted on the market exposure a security has based on the returns it generates. 

Thus, to measure the risks involved while making an investment, the capital asset pricing model (CAPM) comes into play, in which alpha is one of the main components. 

CAPM is based on the principle that an investor should only opt for a high-risk investment if the returns provide ample compensation. To do this, you can use calculate the alpha value of stocks to predict the return on your investment.   

• Jensen’s Alpha

Jensen’s Alpha is a performance index that you can use to predict the abnormal returns that a security may generate in comparison to the theoretically expected returns. These securities can be any financial asset like shares, derivatives or bonds.  

You can calculate it using the formula given below:

Jensen’s Alpha = Actual return – {beta value x (return of index – risk-free rate of return) + risk-free rate of return}

• Technical Analysis Tools

Alpha, along with standard deviation, Sharpe ratio, R-squared and beta, serves as one of the most accurate technical analysis tools for determining the profit potential of an investment. In this regard, alpha serves as a reflection of the rate at which a stock is outperforming the market, and beta shows the volatility of the underlying asset.

This can help you gain insight into the risks and returns associated with your investment and make informed choices.  

What Is the Importance of Alpha in the Stock Market? 

In the stock market, there are many instances in which small and mid-cap organisations outperform large-cap companies due to market upswing and economic boom. Under such circumstances, if you have an aggressive investment strategy, you can calculate the alpha of a stock to understand how it has been performing with respect to its benchmark index and purchase assets accordingly. 

Alternatively, you should consider avoiding stocks that have poor alpha value. It is because a negative alpha value signifies the underperformance of the stock when compared to market performance. 

What Are the Benefits of Alpha in Stock Markets?

Some of the benefits of using alpha in the stock market are as follows:

• When there is an economic uptrend, most businesses, especially small and mid-cap companies, tend to outperform the market. Under such circumstances, investors can use alpha values of the stocks to identify outperforming stocks and invest in them. 
• It is easy to analyse and calculate alpha in stocks. By investing in selected alpha stocks, you can generate a positive alpha return on your portfolio.

What Are the Drawbacks of Alpha in Stock Markets?

Apart from all the advantages alpha offers, it also has some drawbacks. This metric reflects the returns an underlying asset can generate; however, the values may be inconsistent when compared to the market performance. There is an inherent volatility factor that investors must consider. 

Alpha stocks may generate higher returns than the market, which might be temporary; sooner or later, they may fall in line with the market index. When this happens, there is a risk of incurring heavy losses. 

Final Word

By calculating the alpha of a stock, you can assess its ability to outperform its benchmark index and its competitor stocks. However, experts suggest that you should consider checking the beta values along with alpha to get a clearer insight into the risks and returns involved.   

Frequently Asked Questions