It’s no coincidence that many investment publications refer to alpha as the end all be all for investors. The reason? It’s an easy way to determine if the investment (namely a mutual fund) is earning the kinds of returns you would expect given a certain level of risk. Risk-adjusted returns are very important to consider when investing, especially if you’re the kind of investor whose very concerned at the potential of losing money. If this sounds like you, then you had better learn a thing or two about Jensen’s alpha.

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What is Jensen’s ‘Alpha’

Jensen’s Alpha is used in finance to represent two things:

1. A measure of performance on a risk-adjusted basis, and is represented by the following formula:

Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index used as a benchmark, since they are often considered to represent the market’s movement as a whole. The excess returns of a fund relative to the return of a benchmark index is the fund’s alpha.

Alpha is most often used for mutual funds and other similar investment types. It is often represented as a single number (like 3 or -5), but this refers to a percentage measuring how the portfolio or fund performed compared to the benchmark index (i.e. 3% better or 5% worse).

Alpha is often used with beta, which measures volatility or risk, and is also often referred to as “excess return” or “abnormal rate of return.”

2. The abnormal rate of return on a security or portfolio in excess of what would be predicted by an equilibrium model like the capital asset pricing model (CAPM).