Investors and analysts use a wide range of technical indicators to assess the relative risk associated with a given stock. Optimal risk management involves being able to assess an investment’s risk and profitability potential from all angles, including its performance relative to that of the broader market. Consistent underperformance may be an indicator of limited growth potential or inefficient business practices. Alpha is an important tool for many investors when trying to figure out if their investments are doing well.
Key Takeaways
- Alpha is an important tool for many investors when trying to figure out if their investments are doing well.
- A positive alpha indicates the security is outperforming the market.
- Conversely, a negative alpha indicates the security fails to generate returns at the same rate as the market benchmark.
- Alpha is more useful in the context of overall portfolio analysis because the distribution of investment capital over several different securities allows for diversification.
What Is Alpha?
One of the most popular metrics for comparing a company’s performance to that of the wider market is alpha. Essentially, alpha reflects the degree to which a stock’s returns meet or exceed the returns generated by the market.
A stock with an alpha of zero performs in line with the market. A positive alpha indicates the security is outperforming the market. Conversely, a negative alpha indicates the security fails to generate returns at the same rate as the broader sector. So, according to this definition, a stock with a negative alpha is underperforming. However, does this mean you should sell as soon as this metric dips below zero?
Negative Alpha as a Signal
Consistent underperformance can be a huge red flag. However, by using market returns as the baseline for performance evaluation, alpha assumes that the risk level of the individual security—which is called company-specific risk—is comparable to that of the market, called systematic risk. For this reason, alpha is more useful in the context of overall portfolio analysis because the distribution of investment capital over several different securities allows for diversification.
Optimal diversification can completely negate company-specific risk, making the overall risk of the portfolio equal to the risk of the market. Since this kind of diversification is impossible with single-security investments, alpha is a less accurate reflection of performance. In single-security investments, a negative alpha isn’t necessarily a signal to sell if the security is still generating returns.
In portfolio management, a negative alpha indicates that your investments aren’t optimally diversified. In portfolio management, alpha takes the fund’s return and subtracts the return expected from its beta to uncover any excess. For a mutual fund manager or an overall strategy, alpha can indicate the overall effectiveness of the fund or the strategy. In addition, alpha can also gauge how well a manager can pick stocks.
However, alpha is just one metric that should be analyzed when creating an investment strategy. As with any other indicator, it is important to take a comprehensive view of an investment’s relative risk rather than basing decisions on one value alone.
Read the original article on Investopedia.