Understanding Alpha in Investments

Alpha is a historical measure of an asset’s return on investment compared to the risk adjusted expected return.

WHAT DOES ALPHA MEAN IN INVESTMENTS?

Alpha is used to measure performance on a risk adjusted basis. The goal is to know if an investor is being compensated for the volatility risk taken. The return on investment might be better than a benchmark but still not compensate for the assumption of the volatility risk.

An alpha of zero means the investment has exactly earned a return adequate for the volatility assumed. An alpha over zero means the investment has earned a return that has more than compensated for the volatility risk taken. An alpha of less than zero means the investment has earned a return that has not compensated for the volatility risk assumed.

By risk adjusted we mean an investment return should compensate for beta (volatility) 1. According to Modern Portfolio Theory if an investment is twice as volatile as the benchmark an investor should receive twice the return for assuming the additional volatility risk. If an investment is less volatile than the benchmark an investor could receive less return than the benchmark and still be fairly compensated for the amount of volatility risk taken.