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Alpha in Stock Market: Meaning, Limitation and Importance

10 Mins 04 Aug 2023 0 COMMENT

The primary goal of traders and investors is to earn returns and make profits. It is critical to evaluate and analyze the performance of the strategies applied for trading in relation to the overall market. Here, investors can use Alpha to measure the performance of an investment strategy against the returns of the broader market. This allows investors to assess the strategy’s performance and make decisions to optimize returns.

Alpha is a useful technical ratio in the finance world. Traders and investors should know what is alpha in stock market as it can help one to evaluate the absolute performance of an investment compared to that of the benchmark index.

What is alpha?

Alpha is a metric used to determine an investment’s ability to beat the broader market or a benchmark index. Denoted by the Greek letter ‘α’, Alpha is used to measure the value at which a stock’s performance deviates from the performance of a benchmark index. Simply, it calculates the performance of an investment against a market index or benchmark.

If a fund is actively managed, the yield generated by the fund can either be lower or higher than that of the average performance of the broader market. The difference between the two is known as alpha of the fund.

We can understand alpha in stock market better with the help of an example.

If a benchmark index has generated a return of 10% in a year while an actively managed fund generated returns of 12% during the same period of time, then the alpha is the difference between the two i.e., 2%.

The value of alpha in the stock market can be positive or negative based on the performance of the securities. If the assets or portfolio outperformed the benchmark index or market, it generates positive alpha. A negative alpha denotes that the portfolio or assets have underperformed the benchmark index or market.

Uses of Alpha

Alpha measures the excess returns that a fund or investment has generated. It also measures the value that a fund or portfolio manager adds to the fund.

Along with various other technical analysis tools like Sharpe ratio, Beta, standard deviation and R-squared, investors can calculate the risk-return of a particular investment. Through diversifying a portfolio, fund managers try to generate alpha in order to beat the benchmark index. A diverse investment portfolio can help reduce unsystematic risk.

Importance of Alpha

Alpha is a very important tool to track a fund or investment’s performance in comparison to the benchmark index.

Investors can make use of technical tools like a beta in conjunction with alpha. Beta measures the underlying risk and volatility of a security. This helps investors to understand the risk-reward of investment better and make informed decisions.

During market up-swings and economic boom periods, the broad market tends to perform well. In this case, small and mid-cap stocks tend to outperform the market. Investors can focus on funds focused on these shares as they provide higher alpha which can help earn more returns than the broader market.

Although, the generation of alpha depends on the investment strategy and approach of the fund manager. Alpha can also be used as a comparative tool while selecting a fund to invest their money in.

Limitations of Alpha

One of the major limitations of alpha is that it contradicts the efficient market hypothesis (EMH). This hypothesis states that the shares trade at a fair price on the exchanges and the share price reflects all the available information, while it is impossible to ‘beat the market’ consistently.

Statistics suggest that a fund generating relatively higher yields is unlikely to do so at a later date, as share prices fluctuate in tune with their performance and adjust accordingly to reflect their real value.

Moreover, the portfolio that generates relatively higher returns may not continue doing so as the prices of shares fluctuate and can adjust to real values. Many investors, thus, are investing in smart beta funds in order to overcome this limitation of alpha. It should also be noted that generating alpha is not always easy and many funds have failed to beat the benchmark indices. For this reason, investors have started focusing more on index-tracking funds which closely try to replicate the returns generated by the index.

In order to limit the beta risk, fund managers invest in a diverse portfolio. Due to this, some people believe that alpha does not exist and is just the benefit received for taking on additional or unhedged risk.

In conclusion, alpha is a great tool for investors as it can help track performance and by using it with other tools, one can maximize the risk-to-reward ratio. However, an investor should not solely rely on alpha while making investment decisions or analyzing a fund as there are several other factors that can affect an investment’s performance.

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