What is Alpha in the Stock Market?

Last Updated on January 4, 2024 by BFSLTeam BFSLTeam

The Greek letter, alpha, depicted as “α” is also a way of analysing stocks in the stock markets. Alpha in stocks generally refers to a method of stock analysis through technical analysis methods. Via technical ratios of technical analysis, stock performance may be determined. In stocks, alpha shows the absolute value of any stock’s performance where a stock value deviates from that of a benchmark index value. 

Alpha in the Stock Market

In the stock market, alpha is extensively used as a tracker for the active return that results from an investment and also monitors the level of stock volatility. For instance, in portfolio management, the yield that is generated because of an aggressive portfolio management approach by fund managers is prone to be greater or lesser than the market performance on average (as shown by benchmark index values), and the variation between these two represents the alpha value of a given fund.

As an illustrated example, take an actively managed investment. This may generate a return of 10% during any given period, but the benchmark index value in the same period yields returns of 8%. Hence, alpha stocks are calculated as 2% (the difference of 10% – 8%) as this indicates the extra returns of a fund relative to its correspondent index value. Here, alpha in the stock market meaning is clear, taking into consideration values and limits, plus the relevance of alpha in the stock market. 

Additional Read: Flag Pattern in Trading

What is Alpha in the Stock Market? – Know The Value

The value of alpha in the stock market may be negative or positive. This is so because the value is largely dependent on the underlying stock’s performance. A positive alpha reflects that a specific portfolio or asset has outperformed the market. On the other hand, a negative alpha value reflects that a lower yield has been generated relative to the return of a benchmark index. In terms of index funds of a passive nature, returns of a portfolio that are equal to the yields of the fund result in an alpha value of zero. 

Alpha stocks are typically shown in the form of a percentage, while some securities numerically portray the alpha value for several mutual funds as well as other portfolios. If funds are actively managed, they can have an alpha value of 1.5 or -2.60. The former indicates that the given fund yielded returns of 1.5% higher than the market, and an alpha value of -2.6 implies that the portfolio generation was 2.6% lower than benchmark index returns. This is the way that alpha in stocks works. 

What is Alpha Based On?

Alpha stands as a key component of what is called the capital asset pricing model. This was created to gauge the risk related to an investment and, consequently, its profitability.

You should know by now that any stock market investments come with inherent risks because of several factors like the economy, general factors of demand and supply, and the market cycle, among others. To mitigate loss due to unforeseen price fluctuations, the market exposure of a specific security has to be evaluated according to the returns that are generated.

The capital asset pricing model is mainly based on a certain principle that states that investors should only estimate a higher risk if the returns appropriately compensate for it. Alpha in stocks effectively implements this principle and is therefore made use of by portfolio managers to evaluate the predicted returns to produce profits that are higher than the stock market yield on average.

A Technical Analysis Tool

The alpha value stands as one of the most significant technical analysis tools today. It is used extensively by investors to assess the profitability of any investment because it reflects a precise risk-return ratio linked with a corpus. Widely made use of in modern portfolio theory, with other techniques like the beta value, the Sharpe ratio, R squared, and the standard deviation, the alpha value is relied on by investors regularly.

Modern portfolio theory has the aim of providing efficient investment techniques and strategies to investors who are risk-averse, to produce substantial gains through tools of stock markets. The theory is based on the concept that for any two portfolios assumed to yield equal returns, investors will invest in the one with a lower level of risk.

It is worth mentioning some information about the beta value tool here. While alpha in the stock market is representative of the rate at which a fund outperforms the market on average, the beta value shows the volatility of any underlying stocks. It helps investors get a clear picture of the risks and predicted returns and therefore helps to make informed investment decisions.

Final Lines – The Importance

As mentioned earlier, the alpha value reflects the monetary value that fund managers add to any portfolio. Given the economic boom as well as the resultant market uptick, high returns are generated by a majority of companies. This leads to high index points. At times such as these, small and mid-capitalisation companies are prone to outperforming the market. They make gains that tend to be higher than those of the big blue-chip firms. 

For those portfolio managers who have an aggressive investment strategy, they mainly buy shares of such funds and gain a positive alpha value. The excess in return percentage over the market rates that are generated can be blamed on the strategies of portfolio fund managers. In contrast, negative alpha values indicate poor fund performance even if a positive return was produced through an investment strategy. This takes place due to the inefficient allocation of funds.

The alpha value is a constructive and efficient tool used by a majority of investors dealing in stocks today. One of the most popular tools, it has gained recognition as a strategy to predict returns along with other stock indicators and can be used as a component of a wider stock investment plan. 

*Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing. This content is for educational purposes only*