Alpha in Investing
Alpha is one of the most complicated concepts in investing. It’s most commonly used to describe an investor’s ability to beat the market and is measured using the Sharpe Ratio or information ratio. But alpha is rarely discussed, even though it’s an important concept to understand. In this post, we’ll take a look at the basic definition of alpha and show you how to calculate alpha.
What Is the Alpha Formula?
We can use historical data gathered by hedge fund research firm Preqin to explain how alpha is calculated. First, we’re going to measure the asset class’s performance (e.g. the S&P 500), and then we’re going to measure our portfolio’s performance (which is volatility-adjusted). Now, we’re ready to calculate alpha. We can use one of three methods:
The Sharpe Ratio
We can use the Sharpe Ratio to measure the return of the portfolio with respect to volatility. The ratio is calculated using the following formula:
The information ratio
An alternative method is to use the information ratio. The information ratio is measured by dividing the excess return rate by the information ratio associated with the benchmark.
Alpha in Practice
Before we delve into the concept of alpha, let’s first take a brief look at the two most common ways in which stocks are priced:The Efficient Market Hypothesis (EMH) is a theory about the behavior of financial markets.
It says that the valuation of a stock cannot be predicted with any certainty. In fact, it’s impossible to make a prediction about a stock price other than by observing that it has moved in the past.
The theory suggests that since stock prices are always changing – and no one can predict what will happen next – it’s impossible to invest successfully, since the share price will move before you can make a profit. (High tides raise all boats to the same level.)
The EMH argues that once the stock price moves, information becomes widely available, and everyone knows the new price, there’s no point in trying to keep up with the news. Share prices will be pushed back to this new stable level, and any additional effort will only lead to losses.