Slashing through the BS and putting common personal finance expressions in plain terms.
Like physicists and public health officials, investors use Greek letters to name specific things. And before you ask—no, investors haven’t yet found a use for Omicron.
Let’s start from the top. Alpha is a metric that compares an investment’s performance against a benchmark, which is often an index like the S&P 500.
It’s similar to (but not the same as) beta, the measure for short-term volatility that I introduced to you a few weeks ago. Unlike beta, which you can find listed on platforms like Robinhood and sites like Yahoo Finance, alpha only really gets talked about in the context of actively managed funds and portfolios. Fund managers are providing value to their investors when they produce a positive alpha.
Say you’re looking at an actively managed mutual fund. The hypothetical fund returned 4.3% over the past 12 months, and the benchmark index returned 6% over the same period. The alpha is -2.7.
- Any alpha above 0 is good, and anything below it implies that the investment has underperformed its benchmark—not good.
It’s important to compare your investment against the right benchmark. Comparing alphas that use different benchmarks could skew your investment decisions, and sometimes investors pick the wrong benchmark, which could make the alpha calculation useless.
A couple things to know: