What Is Alpha?
Alpha is a concept designed to help investors judge the performance of a mutual fund manager, individual stock, or other investment. It’s often used together with beta, which is a measure of an investment's volatility.
Alpha measures performance against a benchmark, such as the S&P 500 Index. A positive alpha of 1.0 means the fund or stock has outperformed its benchmark by 1% over the period measured. Similarly, an alpha of negative 1.0 indicates underperformance by 1%. Said another way, assume a hypothetical fund returns 10% in a given year and its benchmark gains 7% over the same period. The fund's alpha for the year would be 3.0. (10% - 7%).
Because it’s measured against a benchmark, alpha can help investors identify funds and fund managers who truly beat their benchmark, not simply those who may outperform the benchmark by assuming more risk. That’s why alpha and beta often go together. Most investors would probably prefer a high alpha number and a low beta number, because that would indicate that the fund or stock outperforms its benchmark without a lot of volatility.
Of course, alpha and beta alone cannot compensate for a complete investment strategy and past performance is no guarantee of future results. Therefore, investors may wish to seek the counsel of a trusted financial advisor to help them construct a portfolio that meets their individual needs.