In all the scenarios, the excess returns on the fund are plotted against the excess returns on the market. Now we will have a look at three different scenarios of market performance accompanied with the diagrams. We will use the CAPM formula as an example to illustrate how Alpha works exactly:īeta = systemic risk of a portfolio (the security’s or portfolio’s price volatility relative to the overall market) Mathematically speaking, Alpha is the rate of return that exceeds a financial expectation. Jensen’s Alpha causes some debates, however, as some economists argue that most managers fail to beat the market over the long run due to the efficient market hypothesis, and therefore attribute Alpha to luck instead of portfolio managers’ skills. Bluntly speaking, it tells you if investment decisions were good or bad. whether the manager’s skill has added value to a fund on a risk-adjusted basis. Thus, it allows the investor to statistically test whether portfolio produced an abnormal return relative to the overall capital market i.e. The number you get shows how much better or worse an investment performed relative to its benchmark. It uses a relationship between risk and return (technically called “security market line”) as a benchmark. In finance, Jensen’s index is used to determine the required excess return of a stock, security or portfolio. In other words, Alpha measures how well an investment performed compared to its benchmark. What is Alpha?Īlpha or Jensen Index (invented my Michael Jensen in the 1970s) is an index that is used in some financial models such as the capital asset pricing model (CAPM) to determine the highest possible return on an investment for the least amount of risk. How to calculate Alpha of your portfolioīut before we immediately dive into the nitty-gritty of the Alpha formula, let us define the Alpha first. To do so, you need to calculate the Alpha of your portfolio. So you decided to invest your hard-earned money, and now you want to evaluate whether it was the right decision.
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