Investment Definitions

A couple of definitions all investors should be aware of:

• Correlation - is the extent to which the values of different types of investments move in tandem with one another in response to changing economic and market conditions. Correlation is measured on a scale of -1 to +1. Investments with a correlation of +.5 or more tend to rise and fall in value at the same time. Investments with a negative correlation of -.5 to -1 are more likely to gain or lose value in opposing cycles.

• Sharpe Ratio - used to compare the relationship of risk and reward in following different investment strategies, such as emphasizing growth or value investments, or in holding different combinations of investments. To figure the ratio, the risk-free return is subtracted from the average return of an investment portfolio over a period of time, and the result is divided by the standard deviation of the return. A strategy with a higher ratio is less risky than one with a lower ratio. This type of analysis, which is done using sophisticated computer programs, is named for William P. Sharpe, who won the Nobel Prize in economics in 1990.

• Beta - is a measure of an investment's relative volatility. The higher the beta, the more sharply the value of the investment can be expected to fluctuate in relation to a market index. For example, Standard & Poor's 500-stock Index (S&P 500) has a beta coefficient (or base) of 1. That means if the S&P 500 moves 2% in either direction, a stock with a beta of 1 would also move 2%. Under the same market conditions, however, a stock with a beta of 1.5 would move 3% (2% increase x 1.5 beta = 0.03, or 3%). But a stock with a beta lower than 1 would be expected to be more stable in price and move less. Betas as low as 0.5 and as high as 4 are fairly common, depending on the sector and size of the company. However, in recent years, there has been a lively debate about the validity of assigning and using a beta value as an accurate predictor of stock performance.

• Asset Allocation - is a strategy, advocated by modern portfolio theory, for reducing risk in your investment portfolio in order to maximize return. Specifically, asset allocation means dividing your assets among different broad categories of investments, called asset classes. Stock, bonds, and cash are examples of asset classes, as are real estate and derivatives such as options and futures contracts. Most financial services firms suggest particular asset allocations for specific groups of clients and fine-tune those allocations for individual investors. The asset allocation model — specifically the percentages of your investment principal allocated to each investment category you’re using — that’s appropriate for you at any given time depends on many factors, such as the goals you’re investing to achieve, how much time you have to invest, your tolerance for risk, the direction of interest rates, and the market outlook. Ideally, you adjust or rebalance your portfolio from time to time to bring the allocation back in line with the model you’ve selected. Or, you might realign your model as your financial goals, your time frame, or the market situation changes.

Source:
Glossary, Yahoo Finance