How To Manage Alpha And Risk

By Author: Jamie Hanson
Total Articles: 3534
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One of the most important things for your portfolio is knowing how to manage risk. Alpha can help you do that, along with other important statistical calculations. However, you must be willing to always monitor any position and evaluate whether risks taken pay off or not. Alpha will help an investor see what risks worked and made the fund money as well as the risks that didn't work and lost the fund money. Managing the risk is important and will allow your fund to grow and prosper. However, you need to know how to manage risk and Alpha is an important part of that.

Alpha is a statistical calculation that shows how a particular investment reacted to additional risk. A negative number shows the reward was not worth the risk while a 0 shows the risk neither lost money nor gained money. However, a positive number shows the risk was worth the reward and that the fund increased in value in related to the market as a whole. Keep in mind, though, that just because you see a fund or an investment with a positive alpha it does not mean that it is a great fund to get involved in. The reason why is because until you know how accurate ...
... the alpha number is you can't make any decisions. Alpha calculations are based on beta calculations, which use R Squared. That's another statistical calculation that is quite important in managing a portfolio's risk. If you are interested in the accuracy of alpha check the R Squared number and see how close it is to 100. The closer it is to 100 the more accurate beta, and subsequently alpha, are. Keep this in mind because it is an easy and fast way to see how accurate these numbers are. Once you know what the alpha number is and that it is accurate you can begin managing risk.

If the alpha number is considerably below 0 then you will want to consider whether the damage can be repaired or if the fund is in nosedive mode and needs to be trimmed or cut from the portfolio. There are many considerations that will come into play when you decide whether or not to keep a fund and how to manage the risk involved, but the job becomes much easier when you have alpha, beta, R Squared, and the standard deviation calculations on your side to help you out.

Alpha measures a portfolio's return that is in excess of the market return after both are adjusted for risk. Investors seeking higher alpha can consider long short mutual funds as part of their core portfolio holdings.