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Six common investment terms explained

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01 November 2014, at 12:00am

Dylan Jenkins provides definitions of some common terms, out of hundreds he could have chosen, to help investors trying to make sense of the jargon-filled, often complex world of investment.

When you’re thinking about investing, whether via a pension or an NISA, it can be quite bewildering to be confronted with the endless technical terms and jargon facing you, so I’m going to go through some of the common terms you are likely to come across and attempt to explain them in a manner which everyone can understand.

As most private investment is done via collective investment funds, all of the terms mentioned are related to investment into pooled investment funds. Direct equity investment has many more terms and phrases related to it but this can be dealt with at another time!

1. Alpha

Investing might seem like an art sometimes, but it is more of a science in my opinion. And like all sciences there are ratios and other measures that are unique to investing and which can really be confusing.

Alpha is one of five technical risk measures. For the purposes of this article it can be described as the performance of a fund compared to its benchmark.

So, if a fund is investing in UK shares its benchmark may be the FTSE All-Share index. The manager of the fund is aiming to beat the performance of the index by choosing what he or she believes are the best stocks from those available in that particular index or market.

If the index rises by 5% and the fund rises by 6%, the fund would have an Alpha of +1. If the market rises by 5% and the fund only rises by 4%, the fund would have an Alpha of -1.

Alpha is fundamentally a backward- looking measure. It shows how a fund/ manager has done, which may or may not indicate how they might do in the future.

2. Beta

Beta is another measure of risk, in particular that pertaining to investment volatility, and shows the extent to which a fund will respond to movements in the market. 

A Beta of 1 means that the fund in question will move in line with the market.

A Beta of less than 1 shows that the fund is less volatile than the market and a Beta of more than 1 means that the fund is more volatile. For example if a fund has a Beta of 1.2, it is 20% more volatile than the underlying market. 

Again, this measure is a backward- looking one, but it is nonetheless an important one. It can be a useful indicator of the risk that a manager is taking to achieve his returns.

If you are considering investing in a fund which has performed brilliantly, you should take a look at the Beta and see what kind of a ride the manager has taken.

If, in the pursuit of great gain, the fund has fluctuated in value wildly, with double-digit losses during certain periods, then you need to ask yourself if you can cope with this kind of volatility.

Beta is a particularly useful investment measure as it adds context to performance numbers and is a key measure of risk and return.

3. Standard deviation 

This is another useful measure of risk, and for anyone who did statistics in maths at school, you’ll understand that this is not unique to the investing world. Standard deviation is the extent to which a fund’s return deviates from its mean or average return.

So a volatile stock will have a high standard deviation and a less volatile stock will have a lower one. It is therefore a measure of how rocky a ride the fund has been on.

The calculation is particularly complicated but it does provide a useful bene t as it allows an investor to accurately compare a fund with its peer group.

If two funds have performed largely the same over a set period of time, and yet Fund A has a higher standard deviation than Fund B, then Fund A has been a riskier choice because it has fluctuated more widely in value than Fund B.

4. Asset allocation 

I’ve provided an overview of this in previous articles. Put simply, asset allocation is the process of investing your money in different asset classes in a given proportion. Or, in layman’s terms, the process of not putting all your eggs in one basket.

Asset allocation shouldn’t usually be rigid but should be a more fluid process.

Strategic asset allocation is a long- term process and usually acts as a baseline for allocating one’s portfolio dependent on the objectives set.

Tactical asset allocation on the other hand is much shorter term and takes account of whatever’s going on in the world right now.

Using both to your advantage is key to delivering long-term consistent and dependable investment performance.

5. Rebalancing

When you have set an asset allocation at the outset of an investment it will gradually get out of line from the original weightings. One asset class performs well and another one not so well.

You end up with the first asset class being a larger proportion of your portfolio than it was at outset. If this gets too far out of line, then you can end up with a far riskier portfolio than you intended.

As a result of this, many investors undertake a regular programme of rebalancing. Usually done once a quarter or even once a year, rebalancing resets the weightings between the assets to bring things back to how they were at the start. Many funds and platforms will do this for you automatically.

Doing manual asset allocation is a dif cult discipline as you may not feel like selling out of the higher performing asset class in order to put more back into the lower performing one.

However, whilst painful, this is often a wise course of action to ensuring you remain within your desired risk bracket. 

6. Absolute return

Absolute return funds have become popular in recent years, not least due to the volatile stock markets of the last 6-7 years. The idea is that an absolute return fund will make a return no matter what the market does.

Most conventional funds seek to outperform their competitors or the market – you could say these funds are looking for a relative return, relative to their peers or to the market that is.

But an absolute return fund is looking for just that, an absolute return. Not based on anything else, just a positive investment return.

To do this, an absolute return fund might employ techniques which other funds might not, such as short-selling, using futures and options and other complex financial instruments.

My recommendation is that you and your adviser complete careful due diligence when selecting such a fund within your portfolio.

Not all absolute return funds have lived up to their name and many have actually delivered negative returns over recent years due to the challenging investment conditions over the last 5-10 years.

Summary

I have provided six definitions of terms which can be confusing to many people when they are investing. There are hundreds more I could have chosen and I do empathise with the common investor trying to make sense of the jargon-filled, often complex world of investment.

It is worth mentioning that these definitions are by necessity very cursory. There is plenty more detail to many of them which there simply isn’t time to cover here but there

are a number of excellent websites which can be referred to for further information. My personal favourite is www.investopedia.com, an excellent resource for investing education and personal nance guidance.