# Importance of Alpha and How to Calculate Alpha of an Investment

## Simplified: The Importance of Alpha and How to Calculate the Alpha of an Investment?

Alpha is a performance measuring tool, that is used by many analysts and investors. Can an investor rely only on Alpha and choose the funds? And how can an investor use Alpha effectively and how is it calculated? We are making an attempt to answer all these queries.

### What is Alpha?

Alpha is a performance measure of an investment when compared to an index. Be it stock or mutual fund or a portfolio. The alpha of the particular investment can be calculated using CAPM Model.

A positive alpha, let’s say 4 means that the investment returned 4% excess than its benchmark. In the same way, a negative alpha, let’s say -4 means that the investment returned 4% lower than its benchmark. An alpha of zero means that the investment has returns similar to the benchmark.

#### How is Alpha Calculated?

Capital Asset Pricing Model (CAPM):

In simple terms, CAPM is used to calculate the returns to be earned by an investment to compensate for the risk taken. The measure of risk in the portfolio is called Beta. Thus, CAPM calculates the return to be achieved by investment using Beta as a crucial factor. The formula of CAPM is

R(P) = R(F) + Beta * (R(M)-R(F)) + Alpha
Therefore, Alpha = R(P) - R(F) – Beta * (R(M) – R(F))
R(P) = Return of the portfolio/stock/fund
R(F) = Risk Free Rate of return
R(M) = Benchmark Return
Beta is the systematic risk in the portfolio

Consider an equity mutual fund with last 3 year returns at 15% and last 3 year returns of the benchmark is 12%. Beta of the fund is 1.3 and the risk-free rate is 6%. Then the Alpha of the mutual fund is

Alpha = R(P) - R(F) – Beta * (R(M) – R(F))
= 15% -6% -1.3 * (12%-6%)
= 9% - 7.8
èAlpha = 1.2%

If we try to understand this in detail, in the above example return of the portfolio is 15% and the return of the market (Benchmark or Index) is 12%, thus, by the simple math of subtracting the return of the portfolio from the return of the benchmark we can say that the portfolio has an excess return of 3%. But as per the formula of CAPM, the excess return is 1.20%

Thus, CAPM includes the risk involved in the portfolio in the form of Beta and gives us the actual outperformance of an asset for the risk taken in comparison to the benchmark.

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