Jensen’s alpha

Check out my explanation of one of the most popular financial metrics…

VIDEO SUMMARY

This video is on Jensen’s Alpha. In my last video I talked about finance performance metrics. Alpha, is one of the most famous finance metrics. Alpha was a metric created by Michael Jensen in 1968, to evaluate the performance of mutual fund managers. The goal of alpha is to show how good a finance person is at investing. You want to get as much alpha as possible. The more alpha you have, the better you are at picking stocks.

The equation is very simple. Alpha = ra-re (actual return minus expected return). So you have the return you should have gotten and your actual return and the difference is your alpha. To use some numbers: if your expected return was 12% and you got 15%, your alpha is 3%. 3% represents the value you created from your good financial decision making.

So let’s talk about what’s going on here. If you are going to give your money to some finance professional to invest, you want some metric to tell you how good that person is. Because you could just invest your money in an index fund at a very low cost. So if you are going to pay high fees to someone, you are going to expect a higher return. This person is going to pick stocks to give you a higher return than the market, and alpha will tell you if that is happening.

Let’s take a closer look at the formula. So the actual return is pretty straight forward. You are going to plug in your return. The real question is how do you get the expected return. Well we are going to use our friend the Capital Asset Pricing Model. So the equation becomes alpha = ra-[rf+B(rm-rf)]. So for the capital asset pricing model, you are looking at historical performance for whatever market you are investing in, and getting a sense of what discount people are using for that level of risk. To use the numbers from before, the market is saying you should return 12%, and we want to do better than that. Because it is all about risk. When you purchase a stock, you are paying to hold a certain level of risk, and if you sell the stock and receive a higher rate of return, you just got a good deal.

Why Alpha is so useful is that it ties your performance to expected risk. So let’s say the market return was 10%, and you returned 11%, but the capital asset pricing model suggested you should have returned 12%. In this scenario, you could celebrate that you beat the market. But alpha tells us you should have gotten 12%. The fact you only got 11% means you have a negative alpha and you actually destroyed value, even if you beat the market. Because you weren’t compensated for the level of risk you were holding.

Alpha is a very powerful metric to understand, but it’s not perfect. What you have to realize is that your expected return calculation is based on assumptions. It is not an objective value, so sometimes it can produce curious results. On a practical level, you would use alpha along with many other financial performance metrics to understand your performance. I hope you enjoyed this discussion on alpha. In the next video, I am going to discuss some more financial performance metrics.

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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.