What Does Alpha Mean in Stocks?

Most people are familiar with the word "alpha." It is the first letter in the Greek alphabet. It is used to designate the "star" of a group, such as the alpha male or the alpha star in a constellation. In the Bible, it is used in the term "the beginning and the end" (the alpha and the omega). The meaning is not very different in the world of investing. Most people who invest in stocks do so because they want a return--this is the purpose of investing. Therefore, alpha has come to mean "return" for stockbrokers. Specifically, it is a risk-adjusted metric of an investment portfolio. The portfolio manager with positive alpha is the star.

Origins

In the mid-20th century academics observed that only 25 percent of stock investment managers made more money picking stocks than someone who owned all stocks given a particular market segment. This became known as indexing, or owning a sample of the market. The S&P 500 and NASDAQ are examples of indexes that represent a particular market segment. Owning these indexes is known as passive investment, and fund managers are expected to make a higher return than passive investment strategies. Alpha is the term given to the extra return.

Calculation

Michael Jensen coined the term alpha in relation to portfolio investment strategy in the 1970s. He used the capital asset pricing model (CAPM) to develop a measureable calculation. This model is used by many finance professionals to determine the price for a given asset. Within the context of CAPM, alpha (also known as Jensen's alpha) is a function of portfolio return, the risk-free rate, the portfolio beta and the market return.

Significance

Alpha measures the risk-adjusted return for a given asset. Knowing the value of an asset that is driven by market forces means nothing without gauging the risk associated with owning the asset over a given time period. The best investment is a stock or asset with a high return and limited risk. The hope of most portfolio managers is to be the first to find this market anomaly. Calculating alpha provides fund managers with the ability to compare the risk associated with owning different types of companies in the same industry.

Theories/Speculation

While alpha and CAPM are metrics used by portfolio mangers in practice, finance academics, like Eugene Fama, believe the market is too efficient to find market anomalies. That is, a stock that provides higher returns with lower risk will be in such high demand that market dynamics will push the price of the stock up to compensate.

According to this logic, all stocks have the same alpha, which always equals the risk-free rate. Berkshire Hathaway's stock is a good example. While the risk associated with owning Berkshire Hathaway shares is limited, and the return is high, the price to acquire is so high that few people can afford to own one share, let alone build a portfolio on it.

Interpretation

Alpha is used to evaluate fund performance, but what does the calculation really mean? In general, if the alpha for a stock or portfolio is positive it is said to be an ideal or quality investment that will generate excess returns over a given period of time. However, a negative alpha points to poor future performance; the return does not justify the risk. Knowing the alpha metric for a portfolio or stock is a good way to focus your search for either.

Resources

• Presentation on measuring portfolio performance with CAPM.
• Berkshire Hathaway stock quote on Yahoo