Finance professionals and investors like to throw around ten-dollar words a LOT. It makes them feel good about themselves and seem smarter than they probably actually are. Alpha is one of those words. Let me explain what alpha is in terms of investing.
What is Alpha?
Alpha is simply a term used to describe how much a mutual fund (or any investment fund for that matter) beats or loses to a benchmark portfolio. It is often used in comparing multiple funds against each other.
That might sound a little confusing, but let me explain.
Say you have the option of investing into two funds:
- Adam’s Fund
- Sandler’s Fund
Both funds are benchmarked to the S&P 500. This means that they are essentially comparing themselves to the S&P 500.
Now here are the alphas for Adam’s Fund and Sandler’s Fund:
Adam’s Fund: Alpha of 3
Sandler’s Fund: Alpha of -1.5
Now to complete the example, in a given year the S&P 500 had a gain of 6%.
Because Adam’s Fund had an alpha of 3, that means that Adam’s Fund had a gain of 9%.
And because Sandler’s Fund had a gain of 4.5%.
All an alpha is is how much the fund beat or lost to the underlying benchmark.
The formula looks like this:
Benchmark index gain or loss +/- gain or loss of the selected fund = Alpha
That’s it. 🙂
When to Use Alpha and When to Not
It is important not to use alpha all of the time when comparing investment funds.
The only time that you want to use it is when you are comparing funds that are in the same sector that have the same benchmark.
For example, you might be comparing two technology funds. In that case you would probably want to use the NASDAQ as the benchmark index. And in this case, alpha would be a good indicator of which fund to invest in.
However, if you are comparing two funds that are not in the same sector, the alphas are essentially meaningless. Different sectors with different benchmarks have entirely different “good” and “bad” alphas.
So make sure that if you are using this as a means of choosing your investments, that you are doing so with similar funds.
Final Thoughts
Alpha isn’t really difficult. And it’s one of those investing topics that doesn’t come up all too often but can still be a good tool to have in your tool chest of investing.
But remember, if you are in doubt of what to invest in, consider a general S&P 500 or a target date fund to make it easier. You can always get fancier later. 🙂
You can do this!
Until next time!
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