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Stocks: Should I Stay or Should I Go?
Dear Jeff:
How is alpha used when determining the value of a stock?
Jeff Says:
The Random House dictionary defines "alpha" as the first letter of the Greek alphabet and as the first or the beginning. In a financial context, however, alpha means something very different and much more complex. Essentially, alpha is a measuring total. It measures the difference between a fund's actual returns and its expected performance relative to its level of risk.
The specific level of risk is measured by beta. What is beta, you ask? Beta is what financial experts use to measure the up and down movement in an investment such as a mutual fund. By definition, the market has a beta of 1.00. So, a mutual fund with a beta higher than 1.00 is predicted to move up and down more than the market itself moves and vice versa. For example, a fund with a beta of 1.15 is expected to increase or decrease 15 percent more or less than the market.
Now that we are experts on beta, alpha becomes a little easier to understand. A positive alpha simply means that the fund actually performed much better than its expected return as determined by its beta. The opposite is also true. A negative alpha is an indication that the fund failed to perform to the level of its beta. Like I stated earlier, this is pretty technical stuff.
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