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What is Alpha in Finance? - Definition & Formula

Instructor: Michelle Reichartz

Michelle has lead multiple training initiatives and has a master's degree in Business Administration.

In this lesson, you will learn what alpha is in finance, how it is used to measure return based on risk, and its relationship with beta. You will also learn the formula for calculating alpha.

Understanding the Value of Your Return

Mutual funds and similar investment types are an excellent way to make a profit from your initial deposit. However, how do you know if the performance is above or below the average for an investment of similar risk? Alpha is one way to analyze that.

Defining Alpha

Alpha is known as the difference between a fund's expected returns and its actual returns. Alpha has a very close relationship with another financial term known as beta. Beta is a measure used to determine a fund's expected returns. Along with being the term used for expected returns, beta is also associated with the level of risk.

Alpha is commonly considered the active return on an investment, working as a gauge to determine how a fund is performing against the average. In some cases, the alpha can be construed as the value a portfolio manager can bring to a fund. A smart manager will be capable of exceeding the expected returns, bringing a positive alpha. A manager who is not as successful and does not perform as expected will yield a negative alpha. However, a positive alpha can also be due to luck with the markets. There is no way to determine which is the case.

Calculating Alpha

Calculating the alpha for a fund can be tricky and involves a number of factors. The formula for alpha is:

Alpha = r - Rf - beta * (Rm- Rf)

r = the security's or portfolio's return

Rf = the risk-free rate of return

beta = systemic risk of a portfolio

Rm = the market return

The final result is a number, either negative or positive, depending on the performance of the fund. The higher your beta, the more difficult it is for your alpha to be a positive number.

A Deeper Look at Alpha

From a quick glance, it may appear that you want funds with the highest alpha. However, after taking a closer look, you will discover that this is not necessarily the case. Like everything else in life, alpha comes with its own weaknesses.

The result of alpha is dependent on the calculation of beta. Since the final beta calculation is used in the formula, any weakness in the one will bring out a weakness in the other. You will need to ensure that the calculations for beta are precise before taking them at face value for use in the alpha calculation.

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