The goal of an investor is to generate the highest return possible with the least amount of risk. One of the metrics investors use to determine a stock's risk-adjusted performance is "alpha," also known as "Jensen's alpha" or the "Jensen index." Alpha is the difference between a stock's actual return and its expected return adjusted for risk. Simply stated, alpha is an analysis figure that measures the performance of an investment as compared against a benchmark index (such as the S&P 500).
Beta Stock Values
To calculate a stock's alpha value, you must first understand its beta value. If alpha is the return on a stock's performance, beta is the risk level a stock presents to a portfolio. A stock's beta value expresses volatility and is its relative risk compared to other market investments.
If beta is greater than 1.0, the risk is higher than the average market risk and its return should be higher than average market returns. Conversely, if beta is less than 1.0, the risk is lower than the average market risk, and the return should be lower than average market returns.
Read More: How to Calculate Portfolio Risk
Capital Asset Pricing Model
The capital asset pricing model is a common and fairly simple formula that is used to compare investments. The capital asset pricing model (CAPM) is used to determine an asset's expected return based on its beta value.
When beta is less than 1.0, the stock's CAPM value will be lower than the average market return. When the beta value is greater than 1.0, the stock's CAPM value will be higher than the average market return. It is important to consider that there are limitations to CAPM and beta for gauging risk.
Calculating and Interpreting Alpha Values
When a stock's actual excess return differs from the return predicted by its CAPM value, the difference between the two values is alpha. To calculate a stock's alpha value, subtract its expected return as determined by the CAPM from its current return value.
For example, if an asset's actual market return is 25 percent and the return predicted by the CAPM is 22 percent, its alpha is equal to 3 percent. Similarly, a stock with an estimated CAPM return of 30 percent and an actual return of 25 percent would have an alpha value of -5 percent.
A positive alpha value indicates that a given stock is performing better than expected, while a negative alpha value indicates that the stock is performing worse than expected. Investors typically view stocks with positive alpha values as good investments likely to produce excess returns. Conversely, investors expect a stock with a negative alpha value to perform poorly.
Considerations Beyond Alpha
No investment is without risk. There is a fine line between investing and gambling, which is why exercising responsible due diligence is the foundation of any investment strategy.
Stocks are typically considered to be riskier investments all around, even with metrics such as alpha or the CAPM. Understanding the limitations and underlying assumptions of these metrics is a part of that due diligence.
There is no foolproof method to selecting stocks. A stock's alpha value does not guarantee its future performance. Similarly, a stock's past performance may not reflect future risk or volatility as indicated by beta.
Quite simply, a stock performing well at the time of the calculation may perform poorly in the future. Likewise, stocks currently producing negative alpha values may not always perform poorly. There are other measurement tools that exist in addition to alpha and beta.
Amanda McMullen is a freelancer who has been writing professionally since 2010. She holds a bachelor's degree in mathematics and statistics and a second bachelor's degree in integrated mathematics education.