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Investing Terms: From Alpha to Zeta (Part 1)

If you watch CNBC or read the Wall Street Journal, you may hear or see terms and acronyms mentioned by market analysts, investment professionals and the financial press.

What do these terms mean?  Although there are many, many terms you may encounter, let’s explain a few of the terms you may need to understand or could be interested in.

Alpha:  Alpha is the abnormal rate of return on a security or portfolio in excess of what would be predicted by an equilibrium model like the capital asset pricing model (CAPM).  Alpha could be generated by investors selecting specific holdings and/or weightings based on investment analysis.  

Beta:  Alpha and beta are two of the five standard technical risk calculations, the other three being the standard deviationR-squared, and Sharpe ratio.  Beta represents the overall volatility of an investment relative to the market, which has a beta of 1.0.  If an investment has a Beta of 1.2, it would be considered 20% more volatile than the overall market.  Both alpha and beta are backwards-looking risk ratios.

CAPM or Capital Asset Pricing Model:  The general idea behind CAPM is that investors are compensated in two ways. There is a risk-free component in the formula and compensates investors for placing money in a risk-free investment like Treasury bills.  The other half of the CAPM formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk in market investments like common stocks.  This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over time and to the market premium, the return of the market in excess of the risk-free rate. 

Correlation:  Correlation (range -1.0 to +1.0) represents the degree to which an investment changes value in relation to another investment or group of investments, such as an index (eg S&P 500 Index).  A well-diversified portfolio would have holdings that have low positive or perhaps negative correlation to other portfolio holdings such that if one investment moves in a direction, others are likely to move less or will move in the opposite direction, potentially maximizing return and minimizing volatility.

Duration:  duration represents the weighted-average time for return of principal for a fixed-income investment.   Duration is used to estimate the percentage price change due to a change in interest rates.  Duration has an inverse relationship to interest rates, ie a bond will decline in market value if interest rates increase above the coupon rate of the bond.  If a bond or fund has a duration of five, if interest rates were to go up by 1%, the bond or fund could be expected to decline in price by 5%.

Efficient Frontier: Sounds like something from a science-fiction movie….but, the efficient frontier is just the line on a  graph depicting the  investments most efficient on a risk-return basis.

Fed Funds Rate:  Isn’t this the same as the prime rate?  No; in the United States, the federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight, on an uncollateralized basis.  These funds maintain the Federal reserve requirement. That's what the nation's central bank require they keep on hand each night. The reserve requirement prevents them from lending out every single dollar they get. It makes sure they have enough cash on hand to start each business day.  The Federal Reserve uses the Fed funds rate as a tool to control U.S. economic growth. That makes it the most important interest rate in the world.  Banks use the Fed funds rate to base all other short-term interest rates such as the prime lending rate.  The prime rate is the interest rate that commercial banks charge their most credit-worthy customers, generally large corporations.

Fundamental analysis:  an analysis or valuation estimate of an investment based on fundamental factors such as earnings growth, book value or cash flow.

Held to Maturity: for Fixed Income instruments, such as Treasury bills, notes or bonds, corporate or municipal bonds, when someone says the price of their bond has fallen, they would suffer a loss if they sold the bond prior to maturity.  If they are held to the maturity date the principal is returned in full to the bond holder (subject to an unexpected adverse event such as a default). 

Index funds: a mutual fund (also many index ETFs available) that represents and strives to mimic the returns of an overall index such as the S&P500 Index or iShares Core US Aggregate Bond Index.  Index funds are low-cost, passive investments in the overall market or segment.

Leading Economic Indicators:  The Composite Index of Leading Indicators is a number used by many economic participants to forecast near term economic growth.  By looking at it in relation to business cycles and general economic conditions, investors and businesses can form expectations about what is ahead, and make better-informed decisions.

Mean return:  There are two means you need to know about.  The arithmetic mean is the mean value we all call, “the average”.  However, the arithmetic mean does not correctly calculate the average compounded return over time. That mean is the geometric mean.  If for example, you have returns over a three-year period of 5%, 3% and 10%, the average would be 6%, but the geometric mean is 5.96% calculated as (((1.05x1.03x1.1)0.3333)-1)x100.  Use of the geometric mean is even more critical when returns over time include negative returns (losses) in one of the time periods.

 

 

Information provided by Treybourne Wealth Planners should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. 

All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful. 

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