Glossary of Investment Terms

Risk and Performance Measurements

Benchmark - a standard that measures the performance of a pre-determined set of securities, used for comparison purposes. Such standards may be based on published indexes or may be customized to suit an investment strategy. A widely used benchmark for stocks and mutual funds is the S&P 500 Index.

Alpha - measures the return that can be attributed to individual security selection, rather than broad market movements. It is often used to determine how much value a manager has added through his or her investment decisions.

Beta - shows how much a portfolio's movements are related to broad market movements. For example, if the S&P 500 goes up by 10 percent and your portfolio goes up by 10 percent as well, then you have a beta of 1. If your portfolio varies by more than its index, beta will be higher than 1; if less, beta will be less than 1.

Standard Deviation - measures the amount by which portfolio returns vary over time. Standard deviation can be broken down into two calculations that measure upside and downside risk.

R-squared - tells us how closely a portfolio's return mirrors that of its benchmark. It gives us a way to measure correlation between portfolios and their indices; for example, a porfolio which is exactly the same as its index will have an R-squared of 100.

Risk Premium - is the amount by which a portfolio's return exceeds that of some risk-free benchmark, like Treasury bills. The idea is that the more risk you take, the higher the returns should be.

Risk-Adjusted Performance Ratios - there are three basic tools for measuring risk-adjusted performance. The Sharpe ratio adjusts portfolio returns based on the amount of standard deviation in returns. The Sortino ratio does the same thing, using downside volatility as the risk measure. The Treynor ratio measures return earned per unit of beta, or market risk.

Dollar-weighted return - This figure measures how much the value of your portfolio has increased or decreased over time. It is most useful in determining how well your portfolio is progressing toward its investment goals. Because dollar-weighted return includes cash flows as well as income and capital appreciation in its calculations, it may not provide an accurate measure of how well the portfolio is performing against its benchmark.

Time-weighted return - This measure minimizes the impact of cash flows to provide a truer measure of performance against a benchmark.

Cumulative annualized returns - Annualized returns represent the average performance per year during a cumulative period. For example, a portfolio that has achieved 80 percent cumulative returns over a five-year period has an annualized five-year cumulative return of 12.5 percent.

Net/gross of fees - Performance can be calculated either before or after fees.  Net-of-fee calculations are useful to investors because they show the actual results achieved by the portfolio.  Gross-of-fees calculations are more useful in comparing manager performance, since fee schedules can vary significantly from portfolio to portfolio.