In investing, you'll often hear professional investors talk about trying to maximize their "alpha." In simplest terms, the alpha of an investment portfolio is the percentage by which the portfolio outperforms or underperforms its benchmark index. It represents the value that active management can add to a portfolio above and beyond the performance of the broader market. The greater the alpha, the stronger the portfolio -- but alpha can also be negative, reflecting inferior stock selection.
Alpha is also defined as the return in excess of what the capital asset pricing model would predict. Let's go over what this all means to everyday investors.
Alpha and the capital asset pricing model
The capital asset pricing model seeks to predict the return of an investment based on its risk level, the returns of the overall market, and the specific investments chosen. The term "beta" is used to define risk as a measure of sensitivity to market movements. For instance, if the beta of a portfolio is 2, then movements in the investment portfolio will tend to be double those of the underlying market. A beta of 1 exactly matches the magnitude of market movements, while a beta of 0.5 implies a volatility level that's half the stock market's.
What alpha measures is the return that can't be explained by stock market movements. If the market were efficient in economic terms, then the alpha of any given portfolio should theoretically be zero. However, because real-life markets don't meet the terms of the efficient market hypothesis, you can find portfolios that have positive alpha. This means that the total return is greater than would normally be expected, considering the level of risk involved.
The challenges of using alpha
Clearly, achieving positive alpha means earning better returns than the norm based on how much risk you're taking. However, it can be hard to distinguish true alpha from false indicators of the measure.
One common example of a potential mistake is using the wrong market benchmark as the representation of the broader stock market. For instance, small-cap stocks tend to have a higher return than their large-cap counterparts. If you use a large-cap benchmark in the capital asset pricing model when evaluating a small-cap stock portfolio, then you'll get a higher level of alpha because you'll underestimate how much of the portfolio's return owes to movements in the broader small-cap market.
Nevertheless, as a general concept, striving to maximize alpha is every investor's goal. Your best chance to find positive alpha is to choose investments that have the greatest potential for outsized returns and have a margin of safety that reduces their overall risk level.
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