The investing term alpha coefficient refers to a measure of an asset's risk-adjusted performance. Alpha is a measure of "excess" returns and is frequently used along with beta values to judge the performance of an individual stock or mutual fund manager.
Alpha = Return of Asset - (Risk Free Rate + (Benchmark Return - Risk Free Rate) x Beta)
An online alpha spreadsheet is available to perform these calculations.
Alpha is a measure of an investment's return relative to its risk. The calculation compares the investment's return to that of a risk-free security such as Treasury Bills, and relative to a benchmark such as the S&P 500 Index.
Interpreting alpha is fairly straightforward, and requires the knowledge of only three rules:
Like the beta coefficient, alpha is a key metric used in the capital asset pricing model. The calculation of alpha had its beginnings when academics challenged the notion that mutual fund managers could consistently outperform what was thought to be an efficient market in terms of information. To this day, it's often used to evaluate the performance of mutual fund managers.
The performance of Mutual Fund A's manager over the last three years was measured against the S&P 500 Index. The spreadsheet referenced earlier indicates Company A's alpha was 0.10. The interpretation of this value is as follows:
Since the alpha is greater than 0, Mutual Fund A's return is higher than predicted based on its risk. In fact, with an alpha of 0.10, the mutual fund provided excess returns of 10%. If the CAPM predicted a return of 5%, Mutual Fund A's returns were 15%.