Wall Street Word WorldSubmitted by MD Wendell Wealth Partner on March 31st, 2014
By Mark Wendell
(Source: All definitions extracted from www.investopedia.com)
Wall Street is replete with vocabulary that seems to be a mysterious foreign language. With an education objective, listed below are some important concepts frequently used by Advisors.
Risk Adjusted Return – A concept that defines an investment’s return by measuring how much risk is involved in producing that return, which is generally expressed as a number or rating. Risk-adjusted returns are applied to individual securities and investment funds and portfolios. There are five principal risk measures: alpha, beta, R-squared, standard deviation and Sharpe ratio. Each risk measure is unique in how it measures risk.
Sharpe Ratio – A ratio developed by Nobel laureate William F. Sharpe to measure risk-adjusted performance. The Sharpe ratio tells us whether a portfolio’s returns are due to smart investment decisions or a result of excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater a portfolio’s Sharpe ratio, the better its risk-adjusted performance has been.
Standard Deviation – A measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of variance, and is applied to the annual rate of return of an investment to measure the investment’s volatility.
Alpha – Alpha is often considered to represent the value that a portfolio manager adds to or subtracts from a fund’s return. It represents the amount the portfolio should earn based on the risk of the portfolio vs. what the portfolio actually earned.
Beta – A measure of volatility of a stock or a portfolio in comparison to the market as a whole. Beta measures the tendency of a security’s returns to respond to swings in the market. A beta of 1 indicates that the security’s price will move with the market. A beta of less than 1 means that the security will be less volatile than the market. A beta of greater than 1 indicates that the security’s price will be more volatile than the market.
R²- A statistical measure that represents the percentage of a fund or security’s movements that can be explained by movements in a benchmark index. An R-squared of 100 means that all movements of a security are completely explained by and in line with movements in the index. A fund with a low R-squared (70 or less) doesn’t act much like the index.
Price Earnings Ratio (P/E) – A valuation ratio of a company’s current share price compared to its per-share earnings. EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the estimates of earnings expected in the next four quarters (projected or forward P/E). In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. The P/E is sometimes referred to as the “multiple”, because it shows how much investors are willing to pay per dollar of earnings.
Sovereign Debt – Bonds issued by a national government in a foreign currency, in order to finance the issuing country’s growth. Sovereign debt is generally a riskier investment when it comes from a developing country and a safer investment when it comes from a developed country. The stability of the issuing government is an important factor to consider, when assessing the risk of investing in sovereign debt, and sovereign credit ratings help investors weigh this risk. An unfavorable change in exchange rates, and an overly optimistic valuation of the payback from the projects that the debt is used to finance, can make it difficult for countries to repay sovereign debt.
Monetized Debt – To monetize debt is to convert an asset into or establish something as money or legal tender. The term monetize has different meanings depending on the context. It can refer to methods utilized to generate profit, while it also can literally mean the conversion of an asset into money. For example, the U.S. Federal Reserve can monetize the nation’s debt; this involves the process of purchasing debt (treasuries) which in turn increases the money supply. This essentially turns the debt into money.
Inflation – The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. Central banks attempt to stop severe inflation, along with severe deflation, in an attempt to keep the excessive growth of prices to a minimum.
Deflation – A general decline in prices, often caused by a reduction in the supply of money or credit. Deflation can be caused also by a decrease in government, personal or investment spending. The opposite of inflation, deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression. Central banks attempt to stop severe deflation in an attempt to keep the excessive drop in prices to a minimum. Declining prices, if they persist, generally create a vicious spiral of negatives such as falling profits, closing factories, shrinking employment and incomes, and increasing defaults on loans by companies and individuals. To counter deflation, the Federal Reserve can use monetary policy to increase the money supply and deliberately induce rising prices, causing inflation.
Disinflation – A slowing in the rate of price inflation. Disinflation is used to describe instances when the inflation rate has reduced marginally over the short term. Although it is used to describe periods of slowing inflation, disinflation should not be confused with deflation. Disinflation is commonly used by the Federal Reserve to describe situations of slowing inflation. Although sometimes confused with deflation, disinflation is not considered to be as problematic because prices do not actually drop and disinflation does not usually signal the onset of a slowing economy.