You might hear experienced investors talk about alpha, one of the five risk ratios of technical investment. It’s common when discussing the performance of a security against the market. Investors “seek” alpha as part of their strategy. But what is alpha investing, exactly?

You don’t need to be a technical investor to understand the concept of alpha investing. Understanding what alpha is, what it represents and how to measure it can pave the way for smarter decision making as you pursue strategic investments. Here’s a rundown of alpha and how to strive for market-beating returns by making lucrative investments in different products.

What Is Alpha in Investing?

Alpha – along with beta, r-squared, standard deviation and the Sharpe ratio – is a risk ratio. It’s a specific measurement of the worth of an investment based on its performance relative to the market. Specifically, alpha measures the ability of an investment to beat market returns. Alpha is synonymous with abnormal rate of return.

To find alpha, you simply take the return of a fund and compare it with the return of a benchmark over the same time period. For example, if an exchange-traded fund (ETF) that tracks the S&P 500 returned 14% over the past 52 weeks and the S&P 500 returned 10%, alpha for the ETF would be +4. It’s a quick, simple way to identify better-than-expected performance.

That said, alpha is a measure of price risk, so risk needs to factor into the calculation. There’s a way to measure this using Jensen’s alpha, which includes a risk-adjusted component in its calculation. The formula for Jensen’s alpha is below.

Alpha = R – Rf – beta (Rm – Rf)

R represents the portfolio return.

Rf represents the risk-free rate of return.

Beta represents the systematic risk of a portfolio.

Rm represents the market return, per a benchmark.

What Can Alpha Tell You?

Alpha shows the price risk of an investment relative to others like it. Positive alpha means the reward outweighs the risk. Negative alpha means the investment isn’t meeting expectations or lags behind market returns. For example, alpha of +5 can indicate that a stock is more likely to produce a higher return on investment than the securities it’s benchmarked against. Conversely, alpha of -5 suggests the stock isn’t performing at a standard level.

Alpha by itself is merely one data point. It’s meant to be a quick look at the efficacy of an investment based solely on its price risk. Positive alpha indicates that it’s worth further investigation.

As part of a thorough evaluation against all major risk ratios, alpha can yield more concrete evidence of a security’s ability to offer returns above the market average. It’s important to realize that modern portfolio theory (alpha investing) believes that markets are efficient – thus, market-beating returns are “abnormal.” Hence, alpha is a representation of abnormal rate of return.

Considerations for Comparing Alpha

When viewing alpha as a standalone quick-comparison metric, it’s important to use it correctly. The No. 1 rule is to benchmark a similar investment product – as close as possible to the security you’re evaluating. For example, compare the alpha of a renewable energy ETF against the index it tracks or a similar ETF. If the alpha is, say, +1.75, it means that ETF is likely to generate 1.75% higher returns than the benchmark.

The other chief consideration when seeking alpha is to keep variables as close together as possible. This means looking at comparisons from a similar risk basis. Remember, the purpose of alpha is to show the path to profit through the best price-risk investment. If risk isn’t the same between the investments you’re comparing, alpha won’t be accurate.

Understand That Alpha Isn’t Infallible

Like all investment benchmarks and evaluation tools, alpha isn’t infallible. It’s subject to misinterpretation and skewed perspective – and, of course, human error when calculating. That said, alpha is one of the most trusted and prized metrics. It receives a lot of attention from investors who model their portfolios around the idea of alpha investing.

Keep in mind that alpha encompasses both risk and return, and marries them together. Risk-averse investors shouldn’t automatically take alpha as a sign to open a position. That investment might still come with significant risk – alpha simply suggests that the returns will likely beat the market. Likewise, alpha doesn’t indicate guaranteed return – there’s no such thing in equity markets. Consider both risk and return together, as a balance.

Seeking Alpha: An Example

What is alpha investing? It’s best illustrated with an example. Say you want to invest in a semiconductor ETF like the iShares Semiconductor ETF (Nasdaq: SOXX). You calculate alpha with a risk-free rate of 7%, beta of 1.2 and market return of 14%. Alpha comes out to 7.2%, or α = +7.2. This signals a good investment – one that’s likely to outperform the benchmark handily.

Finding alpha means finding profit in the market. Or, at the very least, it means balancing risk and reward through more measured investments. Investors seeking alpha will put themselves in a better position to capitalize on investments that mirror historically positive performance and yield future returns above the market average. It’s not the only metric to consider, but there’s a reason it’s one of the most widely used.