Are you thinking about investing? Or maybe you’re already dabbling in stocks through an online brokerage company? Whatever the case may be, you are making an incredible first step toward your financial future. By investing your money instead of spending it, you are an absolutely radical human being. Instead of giving the typical excuse of, “I don’t have enough money to invest,” you are digging into your account and you are finding it. Great job.
While investing is a great thing to do, there is no guarantee that you will earn an income by investing your money in the market. As you may already know, there is an inherent risk when you become a shareholder in a particular company. If you’re like most people, however, you know that there is a risk, but you don’t necessarily know when one investment is riskier than another.
One Measure of Risk
When you start analyzing various companies and their stock offerings, there is often an overabundance of information. So how in the world do you find the risk in any particular stock? One word: “alpha.”
Alpha is one of a few different measures for quantifying the risk of any particular stock. According to Investopedia.com:
Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund’s alpha.
I know, I know, it’s a bunch of jargon that might not mean much to you. It’s not always so important to know the origination of the number, but it is important to know how to read it when factoring in the risk of your investment decision.
Instead of explaining all of the technical terms to death, let’s just get your feet wet with an actual example. If you are looking at a particular fund and its alpha is 1.0, this means that your fund has outperformed its benchmark index by 1%. In other words, based on the risk of your fund, it has actually outperformed what is expected of a typical fund with that same risk. Likewise, if the alpha is −1.0, this means that your fund has underperformed the benchmark index and is not performing as well as you would expect.
Watch Out for Volatility
Just because one fund might have a positive alpha this week, it doesn’t mean that it will continue to outperform the market. For example, let’s say that the analysts predict that your fund should earn 10% based on the inherent risk that it has, but at the next reporting session, your fund actually earns 15%! This is a great thing and the alpha for your fund would show up as 5.0, which as you already know means that your fund has outperformed the benchmark by 5%.
In the next quarter, this alpha can certainly head in the opposite direction. Next quarter, the benchmark earnings for your fund might be 8%, but in actuality, your fund only earns 4%. Sure, it’s great that it still earned money, but based on the risk that you took on by investing in this fund, your return is much less than expected, which is why your alpha will display as −4.0.
Do you know what the latest alpha value is for your funds?
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him here and here.
He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.
He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.