Understanding the technical aspects of stock markets is an important part of equity trading. It helps investors understand the risks and performance aspects of a stock. Alpha is one such technical indicator.
Alpha is basically a measure of the performance of a stock or a fund in comparison to a benchmark index. It tells you if a stock or a fund has beaten the market return or not in a specific period of time and by how much.
It is used to understand returns of an investment as against the benchmark indices like Nifty which is considered as standard market performance. It is also popularly used to check and track the performance of mutual funds.
How does it work
Alpha is usually a number that could be positive or negative. An alpha of Zero (0) shows that the performance of your stock or fund was in line with the overall market performance during a specified period of time.
Meanwhile, an alpha of over 0, say 2, shows that the return of your investment outperformed the benchmark by 2 percent in a specific period of time. This means the return is 2 percent more than the performance of the benchmark in that period.
Meanwhile, a negative alpha, say -2, indicated that the return on your investment underperformed the market by 2 percent in a given time period. This means the return is 2 percent less than the benchmark in that period.
So basically, it tells you how your investment has fared, better or worse, as against the market benchmark.
Other technical tools
Alpha is one of five standard technical tools that is generally used to evaluate a stock. The others are Beta, standard deviation, R-squared, and the Sharpe ratio. While alpha measures the returns, beta is an indicator of volatility as against the benchmark market index. The others are also important tools to build a risk-averse portfolio that can generate substantial returns.
Limitations
Now that we understand that the alpha is a comparison between the return of a stock/fund with the performance of a benchmark, it is important to note that the selection of that benchmark is exceedingly important. A wrong benchmark can change the alpha value and deceive investors.
Say for a small-cap stock, if the index used is large-cap, then the value of alpha will not give a clear picture. Also, alphas should be best used for comparing similar stocks. Comparing an alpha of a penny stock and that of a blue-chip to choose a better option may not be very reliable.
Alpha is a measure of how a stock or fund performed in comparison to a benchmark index. Investors across use it in stocks, mutual funds as well as ETFs to look for one with a high alpha number for a better chance at higher returns in the future.