What Is Alpha? The word “alphabet” was created from the names of the first two letters in the Greek alphabet – alpha and beta. Those terms are used in everyday conversation to describe personalities, characteristics, and behaviors, but the meaning changes a bit when applied to investments.
The alpha of assets like stocks, bonds, and mutual funds measures their individual performance against a predetermined benchmark.
For example, a comparison of Apple’s performance against the Nasdaq as a whole would generate one version of Apple stock’s alpha. A comparison of Apple’s performance against Microsoft’s performance would produce a different alpha. In other words, the alpha changes based on the data used in the calculation, so an asset’s alpha is different depending on the benchmark and the period.
Over time, analysts have expanded on the concept by using different comparators to understand their performance in new ways. For example, one of the most frequently cited versions of the alpha calculation is Jensen’s Alpha, which measures an asset’s actual performance versus its expected performance.
How is the alpha used in evaluating a stock? In a choice between high alpha stocks and low alpha stocks, which is a better buy?
Is A Higher Alpha Better?
The result of an alpha calculation is written as a whole number that ranges from negative to positive. When the alpha is zero, the asset’s performance matches the benchmark exactly. A negative number indicates the asset being measured performed below the benchmark, and a positive number shows the asset performed above the benchmark.
Though it is expressed as a single number, the alpha figure represents a percentage. For example, an alpha of five means the asset performed five percent better than the benchmark, while an alpha of negative five means it performed five percent worse than the benchmark.
When it comes to finance, a higher alpha means higher performance, which is most assuredly better than the alternative. However, the alpha calculation relies on historical data, so it can only illustrate past performance. Continued strong performance is never guaranteed, regardless of how high an alpha gets.
Alpha calculations are helpful in identifying assets that outperform benchmarks, but there is more to the process than finding securities or funds that surpass competitors or the market as a whole. The objective is to use the alpha in conjunction with other data points to determine which stocks, bonds, funds, and other assets consistently demonstrate strong performance in all sorts of market conditions to deliver the best risk-adjusted returns.
Examples Of High Alpha Stocks
Stocks that exhibit significant growth and deliver strong returns get a lot of attention, but when the market is going up, that achievement doesn’t necessarily indicate a company with long-term profit potential.
The best investments generate high returns consistently regardless of market conditions. The wider the gap between an individual asset’s performance and various benchmarks, the more likely it is that the business, fund, or other asset itself is strong. It’s not relying on external economic conditions to deliver returns to investors.
High alpha stocks are often fairly well-known. They become popular because of their ability to outperform their peers or the market as a whole. Examples of high alpha stocks include:
Each of these companies has developed a wide moat, the term Warren Buffett coined for sustainable competitive edge. They have demonstrated their ability to generate better profits than their industry peers and other benchmarks through bull markets, bear markets, and everything in-between.
Pitfalls To Avoid When Finding Alpha
An alpha calculation is only useful if it is based on the right data. The two biggest pitfalls that generate poor results for investors are using the wrong benchmark for comparison or using a timeframe that doesn’t show the big picture.
For example, comparing a tech stock to the S&P 500 Information Technology Index offers relevant information on how a company performed against its peers. Comparing a tech stock to the S&P 500 Ex-Information Technology (Ex-Tech) Index isn’t useful for this purpose.
Along the same lines, examining a tech company’s performance against the S&P 500 looks very different in 2021 vs. 2022. The short single-year timeframe doesn’t consider wider economic conditions over that particularly volatile period.
What’s The Difference Between Alpha And Beta In Finance?
When alpha and beta are used to describe personality traits, the terms are compared to each other. The alpha is first in command, while the beta is the trusty sidekick. In finance, there is no alpha vs. beta – the terms are used to describe independent features of an asset.
A stock’s alpha is the comparison of the individual security’s performance against the performance of a benchmark. Beta, on the other hand, is an examination of volatility. Specifically, beta measures the volatility of an asset as compared to the larger market for the purpose of evaluating risk.
The two calculations offer distinct pieces of data that are more powerful when they are combined. Investors and analysts review an asset’s alpha and beta to understand the balance between risk and reward before moving forward with a trade.
Again, it is important to note that alpha and beta are calculated using historical data, so they can only provide a look back – not a prediction of future results. Wise investors don’t rely on alpha and beta exclusively – these figures are part of a comprehensive review of multiple data points.
In short, high alpha stocks are those that have historically exceeded benchmarks from a performance perspective. That’s always a good thing. High beta stocks are those that have been far more volatile than the market as a whole. Whether that’s good or bad depends on the individual investor.
Investors interested in growth stocks might be willing to take the risks associated with highly volatile assets, while those who prefer steadier, more reliable investments are drawn to the reduced risk of low beta stocks.
How To Build A High Alpha Portfolio
Most investors rely on a mix of stocks, bonds, and mutual funds or ETFs to build their portfolios. When they choose stocks, bonds, and funds with high alphas, they increase the likelihood of strong returns.
However, in some cases, it makes sense to diversify further with other types of assets – especially when the portfolio is quite large. Where do the wealthy put their money and what role does alpha play in that decision?
Investors with large amounts to place often turn to assets like real estate, hedge funds, commodities, and private equity to round out their holdings. The trick is choosing opportunities that strike a comfortable balance between risk and potential reward.
Calculating the alpha of these types of investments can be helpful in decision-making because the underlying principle remains the same. In every case, the best investments are those that have a track record of above-average risk-adjusted returns, no matter what the larger market is doing.
High Alpha Stocks: The Bottom Line
Investors are always in search of high alpha assets, whether they use the term “alpha” or simply reference historical returns. The bottom line is that high alpha stocks, bonds, mutual funds, and other assets are the winners that have consistently beaten the market, regardless of whether it is up or down.
Fund managers are especially focused on alpha calculations in an effort to add value to their portfolios for their shareholders. If they don’t succeed, the higher expenses associated with actively managed funds can’t be justified.
A portfolio made up of high alpha stocks can outperform passive index funds to deliver superior returns – a key difference that investors weigh against the costs associated with a hands-on management approach. It is worth examining the alpha of a fund against a relevant benchmark to determine whether returns outweigh expenses.
However, it isn’t necessary to rely on a fund manager to identify the best stocks and other assets. All of the information necessary to buy alpha stocks, bonds, and other assets is available to individual investors through standard investing tools, resources, and education materials.
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