According to modern portfolio theory, investors can develop an optimum risk-return profile using a diversified portfolio. A portfolio is a blend of investments held by an investor that will match their risk-return profile. A risk-return profile represents the investor's tolerance for risk. For example, a risk-averse investor may choose a portfolio with the least risk and greatest return. The theory holds that return is dependent on risk. Understanding securities markets, as well as making an in-depth analysis of them, is fundamental to developing an optimal portfolio. Two major components of return—alpha return and beta return—are identified using a predictive formula.
An alpha return is an excess return of an investment over a benchmark or index, such as the S&P 500. Alpha return is a measure of nonsystemic risk. Nonsystemic risk is risk that is particular to one company or asset and does not affect the entire economy. For example, if Big Systems Inc. stock has grown by 22 percent over a quarter and the overall market growth for stocks sold in the United States is 18 percent, then Big Systems Inc. is outperforming the market by 4 percent. Beta return is a measure of the volatility of the return of an investment, creating an opportunity for a quick return or loss.
The alpha return is one of five risk ratios used to determine the risk-return profile of portfolios. An alpha return is given as a number that is translated into a percentage over or under the index. Investors see the alpha as the account manager's contribution to the portfolio. An alpha of zero would mean the portfolio is tracking the index exactly and the manager's expertise did not contribute to the fund, such as in this example: Money Company LLC is a financial management firm that Mary Nelson uses to manage her portfolio, which grew by 27 percent this year. The S&P 500 also grew by 27 percent. Money Company earned the same amount for Mary's portfolio as the portfolio would have earned if she had randomly invested without any management.
The most common alpha index against which to compare is the S&P 500 because it offers a broad scope of large-cap companies, and components of the index are updated on a quarterly basis. Large-cap companies, or large-capitalization companies, are companies with a large capitalization value.The alpha is calculated using a formula.
When there is unexpected news that may affect a securities market, the market as a whole will respond accordingly. How well it reacts is its market efficiency. In a perfectly efficient market, called a strong-form efficient market, all information is known to the investors, and an announcement would result in an immediate change to the price with no further adjustments. In a perfectly efficient market, the alpha would be zero because all managers would have the same information and the same ability to change portfolio directions. In a weak-form efficient market, prices are based only on current information, without past knowledge. When a market does not accurately and quickly respond to information, resulting in long-term trends, it is considered inefficient.