Alpha is a term used in finance to describe an investment strategy’s ability to outperform the market. Alpha is thus also often called “excess return,” or “anomalous rate of return,“ which refers to the idea of markets being efficient, and so there’s no way to systematically earn rates of return above the broad market as a group. Alpha is often used with beta (the Greek symbol β) to measure the broad market’s overall volatility or risk, known as systemic market risk.
Alpha is used in financial markets as a measure of performance. It indicates when an investment strategy, trader, or investor has beaten the market return over some time period. Alpha, which is often considered the active return, measures the performance of an investment relative to a market index or benchmark.
The excess return of any investment relative to a benchmark index is its alpha. Alpha may be positive (increasing) or negative (decreasing). It’s the result of active investing, not passive investing. On the other hand, beta can be earned through passive investing.
Key Takeaways
- Alpha refers to the excess return earned on investment above its benchmark return.
- Active portfolio managers seek out opportunities for generating returns in diversified portfolios, where diversification is intended to eliminate systematic risk.
- Because alpha represents the difference between a portfolio’s returns and a benchmark’s returns, it is often considered a measure of a portfolio manager’s skill.
Alpha is one of the five most common technical investment risk ratios. The others are beta (beta), standard deviation (standard deviation), R-squared (R-squared), and the Sharpe MPT uses these measurements to help investors decide which investments to buy and sell. These indicators are intended to help you determine whether an investment has a high or low risk-return profile.
