Technical analysis is an important aspect of stock market investing. Investors use several technical analysis ratios and tools to understand the risks and performance of a specific stock. One of the commonly used ratios is alpha.

What is alpha in stock market used for?

To answer the question on what is alpha in stocks, it is an indicator of the return on an investment when compared to another index that serves as a benchmark of market performance. It is the value at which a stock’s performance takes a deviation from the benchmark value.

In the stock market, apart from gauging performance of stocks, alpha can also be used to identify entry and exit points into the market.

Alpha in stocks is used to understand and monitor returns on investment. Alpha is also commonly used in funds to track performance. Alpha is typically indicated as a single number, which could be in the positive or negative. The number is actually the percentage which is either below or above an index that the price of a stock touched. So, if a stock performed 2 per cent better than the benchmark, the alpha is represented as 2. If it did 4 per cent worse than the index, then it is represented as -4, a negative value. When the alpha is a zero, it is indicative that the stock’s returns are the same as market returns.

Essentially, to the question on what is alpha in stocks, it is the value that shows how well or badly a stock has performed vis-a-vis a benchmark.

Alpha and other ratios

Along with alpha, other ratios are used to judge performance of stocks. One of them, which is used in conjunction, is called beta. While alpha in stocks is a measure of performance and returns, beta is a measure of volatility vis-a-vis the market performance or index.

Other ratios such as the Sharpe ratio, standard deviation and R-squared are frequently used along with alpha and beta to weigh the performance of a stock or a fund.

Jensen’s alpha and CAPM

A more in-depth analysis and understanding of alpha would lead a stock market investor to the term Jensen’s alpha. So, what is Jensen’s alpha? This is a term used when the model of capital asset pricing comes into play. This model, abbreviated as CAPM, uses beta as well to compute the returns expected based on the asset’s beta and expected benchmark/market returns. In this model, both alpha and beta values are used to calculate returns. CAPM aims to forecast returns from an investment on the basis of level of risk, the market returns and the particular investments that have been chosen.

In fact, it was Michael Jensen who was instrumental in creating the alpha index, which is now known as Jensen’s alpha.

If you are using only alpha in stocks, you should consider certain factors before using the value:

Now that you know what is alpha in stock market, you are aware that any basic alpha calculation involves deducting the return on an investment from returns from a benchmark that is comparable. However, it is important to take note that this value works best when you are comparing the performance of similar assets. So, if you want to compare performance of one kind of asset with another, the alpha values you may come up with may not be reliable.

Also, there is the risk of using a wrong benchmark which can change alpha values and mislead an investor. Take, for example, a small cap stock. Small caps typically have higher returns than large caps. So, if you were to use a benchmark of large caps while assessing a portfolio of small caps, the alpha may be higher because you may not have taken into account the fact that the returns are because of the small cap market movements.

Alpha and efficient market hypothesis

The efficient market hypothesis or EHM says that all the information pertaining to stocks or investments are already accounted for in the price of an asset. In other words, an asset’s price reflects every possible and available information at any given time. If one were to go by this hypothesis, every security is priced correctly and appropriately at any point in time, so identifying and taking advantage of mispricing is absent. However, markets in reality don’t always behave as per the hypothesis, and there are stocks and portfolios that show alpha.

Conclusion

The answer to the question on “what is alpha in stock market investments” is that it is a technical analysis ratio that tells you how a stock has performed or yielded results in comparison with a benchmark or a market index. The alpha percentage, often represented in plain numbers such as alpha of 4 or 5, or an alpha of -1, is the value by which a stock or portfolio has outperformed or underperformed vis-a-vis the benchmark. A high alpha means a strong stock and a negative alpha could indicate a weak stock.