How do you know if your investment portfolio is performing better (or worse) than the market?
The answer is your investment alpha.
Alpha is a measure of an investment’s performance compared to a benchmark, like a market index.
If your investments are not meeting or exceeding your benchmark(s) over a time period, then you may need to reevaluate your investments and strategy.
As referenced in my book Making Big Money Decisions, investing in underperforming assets generates considerable opportunity costs and suppresses wealth accumulation. Use the content in this post to ensure you’re getting the best return on your invested money.
By reading this post, you will learn why alpha is a key performance indicator for managing your investment portfolio, and how to calculate and use it to optimize your investment strategy.*
What is an investment portfolio?
An investment portfolio includes all marketable investment instruments such as stocks, bonds and other fixed income, mutual and exchange-traded funds, and commodities. You may own other investments in your financial portfolio, such as business assets, real estate, collectibles, and other property, but those assets are typically harder to value and benchmark. As such, they are not included in your investment alpha calculation.
A diversified investment portfolio involves investing in different instruments to reduce risks and potentially generate higher returns.
Index funds aim to mirror the performance of relevant benchmark indexes, offering investors with market diversification in a single investment.
What is investment alpha?
In investing, alpha (α) is a measure of an investment’s performance compared to a benchmark, like a market index. It essentially tells you how much an investment has outperformed (or underperformed) the expected return for its level of risk.
Here’s a breakdown of what alpha means:
- Positive alpha: If an investment has a positive alpha, it means it returned more than what was expected from the benchmark, indicating that the investment strategy may have some skill or “edge” in beating the market.
- Negative alpha: Conversely, a negative alpha signifies that the investment underperformed the benchmark, suggesting the strategy might not be as effective.
- Zero alpha: An alpha of zero means the investment’s return matched the benchmark’s performance.
Alpha is often used to evaluate actively-managed funds, which aim to outperform the market through security selection and other strategies. By comparing a fund’s alpha to its benchmark, you can get a sense of the manager’s ability to add value through their investment choices.
The reality is that most actively-managed investment funds do not generate positive alpha, with less than 10% of actively-managed large-cap funds beating the market. Although past performance does not guarantee future performance in investing, these past results are driving investors to passively-managed, lower-cost funds.
How is alpha calculated?
There are two main ways to calculate investment alpha.
A more sophisticated method, called Jensen’s alpha, uses the Capital Asset Pricing Model (CAPM) to adjust for the risk of your investment or portfolio. If the alpha number measures fund performance on a risk-adjusted basis, then this is Jensen’s alpha.
A simpler method involves subtracting the return of a benchmark index from the return of your investment or portfolio. This tells you how much your investment or portfolio outperformed (or underperformed) the benchmark over a specific period.
The image below illustrates the simpler alpha method for a specific investment. The Schwab US Large-Cap ETF (SCHX) is benchmarked against multiple indexes.
Against the Dow Jones US TSM Large Cap Index it essentially generates zero alpha for all time periods of one year or greater, but positive alpha if you held SCHX since the fund was launched (on 11/03/2009).
When compared to Morningstar Large Blend category index, SCHX generates a positive alpha for all time periods of one year or more.
To further evaluate the performance of SCHX against competitors in same category, you should also consider factors beyond benchmark returns, like risk and fees.
How can I calculate alpha for my diversified investment portfolio?
If you own a single investment, then it is easy to compare since each fund usually reports returns and benchmarking performance (as shown in the SCHX example). But what if you own multiple investment assets and accounts in your portfolio?
Brokerage firms offer the capability to aggregate accounts for analytical purposes, but may not include access to all your investment accounts or specific investments held in those accounts. If you use a spreadsheet to aggregate investment assets data like I do, then you can calculate a return for your entire investment portfolio and benchmark against similar index(es).
If you can aggregate your portfolio by investment type (stock/bond) and location (domestic/foreign), then you can benchmark your investment returns using the simpler method and calculate the financial value of alpha.
In the illustration below, the retirement investment portfolio (holding 70% stocks/funds and 30% bonds/funds, with 90% invested domestically and 10% in foreign instruments) was compared to two benchmarks**:
- A “moderately aggressive” index that blends two S&P indexes to achieve comparable investment targets for investment types/risks (proportion of stocks to bond investments); and
- The Morningstar Global Allocation index for investment locations, or the proportion of your investments in domestic (US in this case) versus foreign instruments for a similar asset allocation.
The diversified portfolio in the example below gained 7% in the first quarter of 2024, generating a positive alpha of 2.2% against benchmark 1 (type/risk) and 2.7% versus benchmark 2 (location/type). The dollar value of generating positive alpha in this example contributed an impressive $14k-18k of the total $46k portfolio gain for the first quarter of 2024 or ~30-40% of the investment gain.
To find your alpha, please review this infographic and download the MyAlpha worksheet.
Takeaways
- If you have multiple investments and your brokerage firm doesn’t provide an investment alpha for your aggregate portfolio, then calculate the alpha for your diversified portfolio. Feel free to use and customize the MyAlpha worksheet as a guide for benchmarking your performance over time.
- Periodically evaluate your actual/current portfolio asset allocation relative to your target allocation and rebalance it as needed. I recently rebalanced my retirement portfolio after the S&P 500 index reached new highs earlier this year. This growth caused large-cap stock investments to be overweighted in my target portfolio. By rebalancing, the gains from these stock investments were harvested and redistributed to maintain my target asset allocation.
- To compare the performance of specific instruments, use multiple indicators – such as yield, rate of return, alpha, and fund fees – to inform your decisions about new and existing investments. You should be able to research and compare these and other indicators for individual investments using tools in your online brokerage account.
- If you pay a higher fee for an investment, then you should expect a higher return and alpha.
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*The investment information contained in this post is for illustrative purposes only and should not be construed as a recommendation to buy or sell specific securities. Alpha is based on past performance, and past performance does not guarantee future performance.
**The benchmarks you use to calculate alpha will be based on the asset allocation of your investment portfolio. Your benchmarks don’t need to match your asset allocation exactly but should be the closest approximation possible.
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