Implications of the CAPM
For active managers, beta is the most commonly used measure today of a stock’s riskiness. Beta, as a measure of systematic risk, is also a convenient way to compare the riskiness of similar stocks.
Alpha can also be used to judge the success of a portfolio or mutual fund manager. To do this, a beta is calculated for an entire portfolio, and an expected return is calculated for the entire portfolio using CAPM. The alpha of the portfolio is the performance of the fund above its expected return. In fact, calculating the alpha of a portfolio is one of the most common ways to quantify an investment adviser’s performance. A positive alpha shows how much better (or worse) the portfolio’s actual returns were over the performance that can be explained by the market.
Example: At the beginning of the year, your client, Ms. Jones, had a portfolio with an expected return of 4% and a beta of 1.0. The T-bill rate is 2%. At the end of the year, her actual return showed a positive alpha of 2%. What was her actual return on her portfol