Alpha Stocks: Mexican Standoff

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About Alpha Stocks

Alpha is a risk-adjusted measure of the so-called "excess return" on an investment. It is a common measure of assessing an active manager's performance as it is the return in excess of a benchmark index.

The difference between the fair and actually expected rates of return on a stock is called the stock's alpha.

The alpha coefficient (αi) is a parameter in the capital asset pricing model. In fact it is the intercept of the Security Characteristic Line (SCL). One can prove that in an efficient market, the expected value of the alpha coefficient equals the return of the risk free asset: E(αi) = rf.

Therefore the alpha coefficient can be used to determine whether an investment manager or firm has created economic value:

αi < rf: the manager or firm has destroyed value
αi = rf: the manager or firm has neither created nor destroyed value
αi > rf: the manager or firm has created value

The concept and focus on Alpha comes from an observation increasingly made during the middle of the twentieth century, that around 75 percent of stock investment managers did not make as much money picking investments as someone who simply invested in every stock in proportion to the weight it occupied in the overall market in terms of market capitalization, or indexing.

Many academics felt that this was due to the stock market being "efficient" which means that since so many people were paying attention to the stock market all the time, the prices of stocks rapidly moved to the correct price at any one moment, and that only luck made it possible for one manager to achieve better results than another, before fees or taxes were considered.

A belief in efficient markets spawned the creation of market capitalization weighted index funds that seek to replicate the performance of investing in an entire market in the weights that each of the equity securities comprises in the overall market. The best examples are the S&P 500 and the Wilshire 5000 which approximately represent the 500 largest equities and the largest 5000 securities respectively, accounting for approximately 80%+ and 99%+ of the total market capitalization of the US market as a whole.

In fact, to many investors, this phenomenon created a new standard of performance that must be matched: an investment manager should not only avoid losing money for the client and should make a certain amount of money, but in fact should make more money than the passive strategy of investing in everything equally (since this strategy appeared to be statistically more likely to be successful than the strategy of any one investment manager).The name for the additional return above the expected return of the beta adjusted return of the market is called "Alpha".

The Alpha Stocks blog is my way of documenting and focusing on picking stocks that have capital appreciation potential on a risk-adjusted basis, either on a short term basis or for the long term. From time to time I will also add my thoughts and observations on the market and economy in general. Thanks for reading. You are free to comment.

No guarantees are made here. Investing involves risk and you may lose money. This is not meant to be a thorough and complete analysis of a company's stock. My intention is to merely point you in the right direction so you can perform your own due diligence.

Alpha Stocks

Friday, February 15, 2008

Mexican Standoff

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