Alpha Risk - Explained
What is Alpha Risk?
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What is Alpha Risk?
Alpha Risk refers to the risk that a null hypothesis (one which states that there is no difference between two variables) will be discarded even when it is absolutely correct. Usually known as the Type I error, the null hypothesis, in this case, states that there is no difference in two variables that are being tested, like zero or 1. For a null hypothesis to be discarded, there must be someone who feels that there is a difference between both variables when no there actually is none. To reduce the possibility of alpha risks, one must be willing to increase the size of the test or sampling to the point that it matches the population.
How does Alpha Risk Work?
In finance, one can incur an alpha risk in analysing returns of an equity. Let us assume that an investor is looking for good investments, but he or she wants something other than 10% annual returns on equities. In the process, he or she tests samples of returns as well as analyse historical data to check if returns are higher or lower than 10%. After testing, this investor comes up with a result that is higher than 10%, thus rejecting the null hypothesis, which states that there is no significant difference between the two variables. In a case where the original return was actually 8% annually, the investor will be said to have committed a Type I error. Alpha risk can lead to unprofitable investments, as participants might feel that the return is higher than what is actually specified, whereas, it is lower than that.