Many stocks achieve above-market returns because of increased volatility. This is a poor way to achieve higher returns. There is no value-added to this approach when considering long or intermediate term holding periods since statistically, the amplified downside risk will eventually compensate for the amplified upside opportunity. The penalty for being on the wrong side of the market is proportionately enormous. A better strategy is to pick stocks that achieve above-market returns with less than proportional increase in volatility. A volatility-adjusted ranking system penalizes returns of stocks with higher than market volatility. Risk Adjusted Alpha (RAA) is an aggressive volatility-adjusted performance measure which reduces the achieved daily returns of the stock by the returns of the relevant market index, amplified by the relative volatility of the stock to the market index. If a stock's daily returns are twice as high as the index and its daily volatility is twice has high as the index, its volatility-adjusted return is zero. Since RAA is based on relative volatility and is tied to a market index, high RAA-ranked stocks may be more volatile but achieve higher returns. If a stock performs equally to the reference index but has higher volatility, its RAA will be negative. If a stock has twice the volatility of an index and has twice the return, its RAA will be zero. If a stock has the same returns as the index but does it with less volatility, it will have a positive RAA. Selecting stocks by volatility-adjusted performance increases the likelihood that the trader can maintain a fully invested position start-to-finish through the inevitable short-term corrections that occur during intermediate-term cycles. RAA is a variant of the alpha term used in Modern Portfolio Theory to build stock portfolios. Alpha uses “beta” in place of the relative standard deviation term in RAA. Alpha is a measure of performance in percentage above or below what would have been predicted by risk as suggested by its Beta. Positive alpha means a stock performed greater than its risk would suggest, while negative Alpha means the stock under performed. An ETF of Alpha 1.5 outperformed its index by 1.5% as predicted by its Beta.
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