Everybody wants to beat the market -- after all, that's the point of buying individual stocks, isn't it? Well, if that's your goal, there's one important metric to understand: Jensen's alpha. Read on to learn more about this magic number and why it matters so much.
What it is
What is Jensen's alpha?
If you're "seeking alpha," the alpha you're seeking is actually Jensen's alpha. Also known simply as "alpha," Jensen's alpha was formulated by economist Michael Jensen in 1968 as a means to evaluate the performance of portfolio managers versus the wider market. It's since become a measure we can all use to compare our portfolios to the general market.
Jensen's alpha can be used to compare individual stocks or entire portfolios against other investments, both when choosing an investment and when evaluating one's performance. It's a very handy tool to have in your arsenal when you just want to check to see how you're doing.
Its use
Using Jensen's alpha
Jensen's alpha allows you to examine the returns of one type of investment against another by comparing the returns to a benchmark using a capital asset pricing model. You can apply it to any asset, including stocks, bonds, and entire portfolios, and it will use other metrics, such as the beta and average market returns, to help you zero in on the investment you're seeking to better understand.
You can also use it to evaluate your own fund manager to decide whether you're happy with how they're doing or would rather shake things up a little bit. So, if you don't self-manage your investments, using Jensen's alpha can tell you how well your fund managers are doing against wider markets.
Interpreting it
Interpreting Jensen's alpha
Jensen's alpha is pretty easy to understand. There are just three possible outcomes:
- Positive alpha. Positive alpha is the goal. This is when the asset in question has outperformed the benchmark to which it was compared. When you reach a positive alpha, the more, the better. A higher number means better performance.
- Negative alpha. Negative alpha is not what you want, but it is important to uncover if it's happening. Negative means that you've underperformed the benchmark, and you definitely need to refocus your efforts to achieve better results, even if that's simply putting your money into S&P index funds.
- Zero. Zero or neutral alpha is possible when your investments are literally performing the same as the benchmark to which you've compared them.
If you find yourself with a negative or neutral alpha, it's going to be important to dig deeper to find the issue. Sometimes, the issue is simply the benchmark to which you're comparing your investment.
For example, a portfolio of established real estate investment trusts (REITs) is unlikely to outperform one that's made up entirely of highly successful tech stocks. The reason you'd choose the REITs, though, is that you want less risk and less volatility -- even if it means smaller rewards.
On the other hand, if you compare that same basket of REITs to the S&P 500 and it's still underperforming, you probably need to shake things up a bit. That is, unless it's caused by a temporary industry blip that will self-correct in time.
Related investing topics
The calculation
Calculating Jensen's alpha
You need four pieces of information to calculate Jensen's alpha:
- Ri = The realized return of the portfolio or investment in question
- Rm = The realized return of the benchmark or market index
- Rf = The risk-free rate of return for the time period
- B = The beta of the investment portfolio relative to the chosen benchmark
The formula
The formula itself is pretty simple. It looks like this:
Alpha = Ri - (Rf + (B * (Rm - Rf)))
Example
So, let's assume that:
- Ri = 20%
- Rm = 10%
- Rf = 2%
- B = 1.2
The formula would work like this:
Alpha = 20% - (2% + (1.2 * (10% - 2%)))
Alpha = 20% - (2% + 9.6%)
Alpha = 20% - (11.6%)
Alpha = 8.4%
Since it's positive, that means you're beating your benchmark -- so great job, you!
