Financial advisors and investment gurus use a variety of measurements to understand and evaluate stocks, mutual funds, and exchange-traded-funds (ETF). If you’ve ever read a prospectus or a fund fact card, you’ve probably come across words like alpha, beta, correlation, standard deviation, and Sharpe ratio. Today’s post is for those of you who love getting technical. Each of these metrics is defined below.
Alpha: Of all the measurements, alpha may be the most commonly cited. Alpha is a measurement of a portfolio’s risk-adjusted performance compared to its benchmark. Simply stated, alpha measures how well a portfolio manager stacks up against the benchmark by which he or she is measured. A positive reading indicates that the manager is outperforming the benchmark. A negative reading indicates that the portfolio manager is falling behind the benchmark in terms of expected performance.
Beta: Beta is also a very widely used metric. Beta measures the sensitivity or volatility displayed by a portfolio relative to the market. The S&P500 carries a beta measurement of 1. Any measurements above 1 indicate higher volatility relative to the S&P500. Measurements lower than 1 indicate lower comparative volatility. Specifically, a portfolio that measures 0.9 would be 10% less volatile than the S&P500. Investors who wish to be aggressive in their allocation may chose a portfolio with a beta above 1. More conservative investors should choose portfolios with a beta less than 1.
Correlation: Correlation measures and compares how investments react to happenings in the markets. In other words, do two investments display the same behavior in response to positive or negative events? In the simplest terms, correlation measures whether two investments zig together or zig and zag in opposite directions in response to the same event. Correlation ranges from +1 to -1. Perfect correlation is +1. Exact opposite (negative correlation) is -1. Building portfolios with assets that have low correlation relative to each other may help reduce investment risk.
Standard Deviation: Chances are, you learned about standard deviation in your high school or college algebra class. In the investment world, standard deviation measures the consistency or inconsistency of a portfolio’s returns compared to the average return. Higher standard deviation results in increased volatility. Lower volatility suggests more consistent returns.
Sharpe ratio: The Sharpe ratio was developed by Nobel Laureate William Sharpe and measures a portfolio’s risk-adjusted return using standard deviation. The Sharpe ratio strives to determine how much return was driven by excess risk. As investors, we wish to achieve the highest level of return in exchange for the lowest possible level or risk. Higher Sharpe ratios display returns that were achieved with lower levels of risk.
Want to learn more about portfolio metrics? Click here for a helpful brochure courtesy of Nuveen Investments.