Jensen's Alpha is a risk-adjusted performance measure that calculates the excess return earned by an investment portfolio beyond what would be expected based on its risk level. The concept begins with the 'birth right' or risk-free return (approximately 7% in India, achievable through government securities or fixed deposits), which represents the minimum return investors deserve without taking any risk. When investors take on risk, they should expect returns exceeding this baseline. For example, if an investor takes half the risk of Nifty (the Indian stock market index) and earns 9% return, the expected return would be 7% plus a risk premium. If the actual return is 11%, the additional 2% (11% - 9%) represents Jensen's Alpha, indicating the portfolio has outperformed its risk-adjusted expectations. This metric helps investors determine whether their returns are truly worth the risk taken, making it essential for evaluating mutual funds, stocks, and other risk assets.
What is Jensen's Alpha? A Simple Explanation of Risk and Return in InvestingAdded:
Jensen's alpha is one risk measure. If you have to measure it for the portfolio, this is the best risk measure. All of us have a birth right to return, right? If none of us were there and you didn't want to take any risk, what would you do? You would buy government of India paper or an FD at 6.5% 7%. Now, for ease of explanation, 7% is my birth right in this country.
That's called the risk-free return. Now, let's assume I'm ready to take some risk. Let's assume half of Nifty's risk.
I'm ready to take Nifty other risk. Do I deserve seven or more? More than seven?
Because risk about Miller if I getting without a risk if I put some risk as a raw material to this portfolio should I get more than seven? I should get more than seven. Let's assume you take ready to take half the risk of Nifty. You can put half your money in Nifty. This portfolio will have a certain return, right? That is your now your birth right because you're putting risk. Now, let's assume seven is risk-free. If you put half your money in Nifty and half your money in an FD, if you deserve for a specific period 9% return. You deserve 9%. But if another to give 11 or anybody give you 11, is it more than the birth right? That extra is called Jensen's alpha.
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