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Alpha of portfolio



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Alpha in stock market has two meanings. We shall use the meaning of risk-adjusted returns in this lesson.

When we are investing in a security, we wish to measure its performance in terms of returns.

In particular, we will be interested in getting the risk-adjusted return of the security.

Alpha is used just for that.

Alpha is one of the five popular risk measurement ratios we use. The other ratios are beta, standard deviation, R-squared, and the Sharpe ratio.

It tells us how the security we have invest in is performing.

i.e better or worse, compared to the index against which it is measured.

Alpha tell us the "excess return" that the portfolio generated over what was expected.

Alpha is mostly used in mutual funds but serious investors in direct equities too can measure it.

Alpha range

If the Alpha of your investment is less than 0, it means it is under-performing compared to the underlying index.

If the Alpha of your investment is more than 0, it means it is out-performing compared to the underlying index.

How to compute Alpha?

Initial Cash: Rs 100,000

Interest Rate Earned on Cash: 3%

Interest on Cash to date: Rs 175

Loan Interest: Rs 50

Open Position Profit/ Loss:

Reliance: Rs 3,000

Infy : - Rs 2,000

Total Open Position Profit/Loss: Rs 1,000

Beta of Portfolio: 0.12376

No. of Days since Portfolio Start: 50

Return on Benchmark Index: 2%

Actual Return: (Rs 1,000 + Rs 175 – Rs 50) / Rs 100,000 => 1.125%

Expected Return: (50/365 * 3%) + 0.12376 * [2% - (50 / 365 * 3%)] => 0.6%

Alpha of Portfolio = 1.125% - 0.6% = 0.525%

Using Alpha with Beta

Alpha can be used in conjunction with Beta to make better investment decisions.

Conclusions

  • Rule #41: Keep an eye on the Alpha of your portfolio to find if your pf is under-performing or over-performing to the stock market.