10. The Many Meanings of "Alpha"

Disambiguation of the term “Alpha”

You will hear the term “alpha” throughout this program, so we want to let you know early on that the term “alpha” is used to mean multiple things in the investment industry.

In mathematics, you’ll see alpha refer to the significance level of a hypothesis test. In regression, you’ll see alpha refer to the y-intercept of a straight line.

In finance, alpha refers to multiple distinct but somewhat related ideas. The common thread among these definitions is that alpha is the extra value that an investment professional can add to the performance of an investment.

One specific definition of alpha is the extra return that an actively managed fund can deliver, that exceeds the performance of passively investing (buy and hold) in a portfolio of stocks. Another specific definition of alpha, which we’ll primarily focus on in this course, is that of an alpha vector.

An alpha vector is a list of numbers, one for each stock in a portfolio, that gives us a signal as to the relative future performance of these stocks. You’ll learn more about alpha vectors throughout term 1.

Just to be clear, the finance community, both in academia and industry, use alpha to denote multiple ideas.

In this lesson, you may have noticed that we use “alpha” in the statistical sense when we talked about hypothesis testing. We also used it when saying that we may “find alpha” in a strategy. This second usage refers to outsized performance, or better-than-passive performance that a finance professional can add to an investment. Later on, we will use it in the sense of an alpha vector, which is a list of numbers that give us a signal about the relative performance of each stock.