TERMS AND TECHNOLOGY

WHAT YOU WILL LEARN•Terms• Risk• Rebalancing

•Technology•Hypothetical Illustrator• Portfolio Solutions

TERMS – RISK & RETURN•Risk• Alpha• Beta• R2

• Standard Deviation• Sharpe Ratio

TERMS• Beta• This tells us how much risk a portfolio is taking compared to its

benchmark• The benchmark is always assigned a number of 1.00• Example

• The benchmark is the S&P 500• Since the S&P 500 is the benchmark, it is automatically assigned a beta of

1.00• If a portfolio is said to have a beta of 0.90, that means the portfolio is taking

10% less risk than the benchmark• If a portfolio is said to have a beta of 1.10, that means the portfolio is taking

10% more risk than the benchmark• Beta can also be used as an indicator of performance

• R2

• What’s wrong with this statement?• “My portfolio has a beta of 0.90 so it is less risky.”• Less risky than what?• Is that a relevant benchmark to compare it to?

• Which makes more sense?• “My portfolio is less risky than betting all of my money on one

hand of blackjack.”• “My portfolio is less risky than peeing on an electric fence.”

TERMS

• R2 (continued)• R2 helps you determine if you are comparing your

portfolio to something relevant• You can’t talk about the alpha or beta without knowing

what R2 is• According to Morningstar, you should have a R2 of 75 or

higher• If the R2 is less than 75, then alpha and beta numbers are

meaningless

TERMS

• Alpha• Alpha gauges risk and return together• Alpha measures the difference between a portfolio's actual returns

and its expected performance• Alpha is often seen as a measurement of the value added or

subtracted by a portfolio's manager• If a fund returns more than what you'd expect given its beta, it has

a positive alpha• If a fund returns less than its beta predicts, it has a negative alpha

TERMS

• Standard Deviation• Standard deviation measures how much a fund fluctuates

compared its average• Example

• A mutual fund that gained 1% each and every month over the past 36 months would have a standard deviation of zero, because its monthly returns didn't change from one month to the next

• A mutual fund that lost 1% each and every month would also have a standard deviation of zero• Why? Because, again, its returns didn't vary

• A fund that gained 5% one month, 25% the next, and that lost 7% the next would have a much higher standard deviation because its returns have been more varied.

TERMS

• Standard Deviation (continued)• Standard deviation allows a fund's performance swings to be captured into a

single number• For most funds, future monthly returns will fall within one standard deviation of

its average return 68% of the time and within two standard deviations 95% of the time

• Translation• Say a fund has a standard deviation of 4 and an average return of 10% per year• Most of the time (or, more precisely, 68% of the time), we can expect the fund's

future returns to range between 6% and 14% or its 10% average plus or minus its standard deviation of four.

• Almost all of the time (95% of the time), its returns will fall between 2% and 18%, or within two standard deviations of its average

TERMS

Average Return: 10%

Standard Deviation: 4

6% 14%

10%

18%2%

1 Standard Deviation(68% of the time)

2 Standard Deviations

(95% of the time)

1 Standard Deviation(68% of the time)

2 Standard Deviations

(95% of the time)

TERMS

• Sharpe Ratio• The Sharpe ratio uses standard deviation to measure a

fund's risk-adjusted returns• The higher a fund's Sharpe ratio, the better a fund's

returns have been relative to the risk it has taken• Because it uses standard deviation, the Sharpe ratio can

be used to compare risk-adjusted returns across all fund categories (alpha and beta can only be used to compare funds in the same fund category)

TERMS

• Rebalancing• Rebalancing helps put our portfolio back to its intended

allocation• Example:• Initial portfolio design

• Fund A: 50%• Fund B: 50%

• After 1 year• Fund A: 60%• Fund B: 40%

• Rebalancing puts them both back to 50%

TERMS

•Morningstar Tools•Hypothetical Illustrator• Used to prove concepts or show past performance of a

portfolio• Portfolio Solutions• Used to compare past performance of two portfolios

TECHNOLIOGY