THE ABCS (ALPHA, BETA, CORRELATION, …) OF FINANCIAL TERMS

Dynamic Alpha Solutions is committed to simplifying complexity – and that includes the ABCs of financial terminology. 

Having been in the financial services industry for over 25 years, I know that the world of finance has its own complex jargon – but it doesn’t have to make you feel like an outsider. 

A simple Google search for “finance dictionary” turns up thousands of results – which leads to more questions! How do I pick one? Which is the best dictionary for me? How many terms do I really need to know? This added confusion around terminology can not only turn investors off but also create confused investors and clients – not a great recipe for investing success. 

So, let’s simplify the complexity around financial terminology and start helping you feel competent, knowledgeable, and skilled – so you can properly identify appropriate investments.

Return(s) 

As complex as the world of finance is, you might think that ‘return’ is one term that should be easy to understand, but there are several ways to measure and report return. If this were a typical finance article designed to complicate and confuse things, I’d go into ‘arithmetic’ versus ‘geometric’ average return calculations and pretend to sound especially elite. But our goal is to simplify complexity, so we are going to define ‘returns’ – and their categories – in what we believe to be the most impactful ways to help guide you as you develop an appropriate portfolio. 

• Total return: From a most basic standpoint, total return is measured as appreciation plus any reinvested dividends and/or interest. When we use the term ‘return’ we are referring to total return. 
• Correlation:  Although correlation is not a measure of return, it is used to compare two or more investments to one another relative to the sequence of their returns. When two investments move in sync, they have a high correlation and vice versa. This is why we believe in having investments that are noncorrelated. If all your investments go up at the same time, they will, more than likely, all go down at the same time – and that is not good.
• Fixed time-based returns: These are the typical returns shown to investors and advisors. For example, three-year average returns show the total return you would get if you had invested in the fund three years ago and held it to the current time without adding or taking any funds out. The problem with this type of time-based return is that it doesn’t account for the consistency of that return.  
• Rolling time-based returns: To address the fixed time-based returns issue of not accounting for the consistency of returns, the rolling time-based approach measures multiple time frames. For example, a three-year rolling return would look at multiple three-year average returns over time.

Risk

Defining risk is also not as easy as you might think. There are many technical terms, but, in keeping with our motto of simplifying complexity, we will break down the terms as simply as possible. Risk can be easily defined as losing money—but the terms for monies lost must be defined further.

• Standard deviation:  This is generally considered the standard for defining risk. Endless amounts of articles and research have been done on defining risk as standard deviation, and, although there is a basis for using this term, we do not believe it is the best – or even a good – measure of risk. Standard deviation technically measures the volatility of the return from the average return, but the problem is that standard deviation does not measure the direction of the deviation. In my 25 years in financial services, I have never met an investor who didn’t want deviation on the upside! Investors are most concerned about deviation on the downside, so we should be measuring that!
• Loss standard deviation:  This simply measures the deviation of negative returns. We view this as a much more accurate way to measure risk. Unfortunately, most investment fact sheets do not include this statistic. That is why Dynamic Alpha Solutions has created our own fact sheets for investments and portfolios that report this and other important statistics.
• Worst monthly/quarterly returns:  This is probably the most important measure of risk from an investor’s standpoint. An investor doesn’t ‘feel’ a standard deviation, Sharpe ratio, Sortino ratio, or any other fancy risk measure. They ‘feel’ the monthly & quarterly changes. That is why we include the worst monthly & quarterly returns in our fact sheets. It provides robust data for wise investing.

Risk-Adjusted Returns

When you combine return measurements with risk measurements, you get ‘risk-adjusted returns’ (Yes, it’s that simple.).There are several ways to measure risk-adjusted returns, but we will examine the most common and our preferred method.

• Alpha:  A measure of the outperformance of an investment relative to a benchmark. 
• Beta:  A measure of the risk of an investment relative to a benchmark.
  • The issue with both alpha and beta is in the appropriateness of the benchmark utilized. If there is a low correlation between the benchmark and the investment, then the appropriateness of alpha and beta is reduced. Because of this limitation, we tend not to use them as measurements.
• Sharpe ratio: This is one of the most common measures of risk-adjusted returns measuring the return of the investment divided by its standard deviation. (Technically it is the return minus a risk-free return divided by the standard deviation). But, as we learned above, the standard deviation is not the best measure of risk. Thus, although we do examine the Sharpe ratio, it is not our main measure of risk-adjusted returns. 
• Sortino ratio: This is very similar to the Sharpe ratio, however, instead of dividing the return by the standard deviation, it is divided by the loss – or downside – standard deviation. Because we know investors are mostly concerned with deviation on the downside, we believe in measuring the return relative to how much it deviates downwards. This is yet another important statistic seldom reported on normal investment reports.
  • It is very important that, when examining a Sortino ratio, you compare it to another Sortino ratio of a similar category of investments. The higher the number the better, but you can only compare Sortino ratios to other similar funds. For example, you cannot compare a bond fund to a stock fund.

Conclusion

We purposely did not define all financial terms – there are plenty of resources out there that do just that. But, we did attempt to provide you with what we believe are the key financial terms that financial advisors and investors should be aware of when examining an investment or overall portfolio. 

We further believe that there is no perfect investment and no perfect investment measurement tool or statistic. That is why Dynamic Alpha Solutions follows a multi-step process to build our “Multi-Dimensional Asset Allocation” solutions.