Talk the Talk
This glossary is your source for definitions of commonly used finance and investing terms and easy-to-understand explanations of key investing concepts.
Active management: An investing approach in which a portfolio manager attempts to outperform a specified index or benchmark portfolio.
Alpha: A measure of excess risk-adjusted return for, for example, a mutual fund manager.
Alternative investments: Asset classes, such as commodities and real estate, with return and risk qualities that differ significantly from traditional asset classes like stocks and bonds.
Asset allocation: An investment strategy used to construct a portfolio that balances risk and reward. The practice uses multiple asset classes such as stocks, bonds and cash, and takes into account investors’ risk tolerance, time horizon and investment goals.
Behavioral finance: An increasingly accepted school of finance based on the belief and evidence that people’s psychological and emotional state affects and distorts their investment decision making.
Beta: A measure of a stock’s or a portfolio’s sensitivity to movements in the overall stock market. A high beta stock is more volatile than the overall market, which has a beta of 1. A low beta stock is less volatile than the market. Beta is a similar concept as duration is for bonds.
Correlation: A measure of the linear relationship or co-movements between two random variables, such as stocks and bonds. Correlation ranges from -1 to 1, with -1 being perfect negative correlation, 0 indicating no correlation, and 1 representing perfect correlation.
Covariance: A statistical measure of the degree to which returns on two random variables, such as two unrelated stocks, move in sync. If the assets move together, then the covariance is positive.
Dollar cost averaging: An investing strategy of putting money to work gradually over time; for instance, by investing a set amount each month or quarter. The goal is to buy fewer shares when stock prices are high and more when prices are low.
Duration: A measure of interest rate risk; the approximate sensitivity of a fixed-income security, such as a bond, to changes in interest rates.
Earnings yield: A company’s earnings per share divided by stock price; the inverse of a P/E ratio. The S&P 500’s earnings yield is used in the so-called Fed model as a valuation tool.
Efficient frontier: Often drawn on a graph, the efficient frontier describes the set of portfolios that maximize the expected return for a given level of risk (as defined by standard deviation) and minimize risk for a given level of expected return.
Enhanced indexing (also called semi-active management): An investment approach in which the manager attempts to outperform an index or benchmark while maintaining tight control over risk relative to the index or benchmark.
Fed model: A stock valuation model in which the earnings yield of the S&P 500 is compared to the yield- to- maturity of 10-year Treasury bonds. An equity earnings yield well in excess of the Treasury yield implies that stock prices are relatively attractive; an earnings yield less than Treasuries implies that stocks may be fully valued.
Human capital: The present value of expected future labor income during a worker’s lifetime. A worker’s human capital generally peaks at the start of her career, declines over her working years, and is steadily converted into financial capital by saving and investing employment earnings over the course her career.
Indexing: A passive approach to investing in which an investor holds a basket of securities designed to replicate the performance of a specified index of securities. Examples of popular stock indexes include the S&P 500 Index and the MSCI EAFE Index.
Momentum: The tendency of stocks to demonstrate consistent performance over a given period of time (typically three to twelve months), and the tendency of past winners to keep winning and losers to keep losing relative to their peers. Academic research has established that momentum is a systematic source of risk for equity investors, and that momentum investing provides excess stock returns over a market index.
Multi-factor model: Stock investment strategy that incorporates multiple risk factors (such as company size and price) to explain the performance of a stock portfolio; i.e., a portfolio’s expected return is determined by its exposure to various risk factors. Multi-factor models may be based on macro-economic, fundamental or statistical factors.
Passive management: Holding a portfolio of securities that are intended to mimic the returns on a selected index, such as the Russell 1000.
Rebalancing: Altering a portfolio to return asset class weights to the strategic asset allocation. For example, a period of gains for stocks and losses for bonds may require selling stocks and purchasing bonds to restore an investor’s strategic asset allocation levels.
Risk factor: Variables, such as interest rates or inflation, which determine an asset’s returns under the asset pricing model of arbitrage pricing theory (APT).
Risk management: The process of identifying and measuring risks and devising ways to mitigate the risks in investment decision-making.
Risk premium: The expected return on an investment, minus the risk-free rate. For instance, if the expected return for stocks is 10% and the risk-free is 3%, the risk premium is 7%.
Sharpe Ratio: A measure of risk adjusted return that, for example, compares a portfolio’s excess return vs. a benchmark, to the volatility (as measured by standard deviation) of the portfolio.
Socially responsible investing: An investing approach that combines ethical values and social concerns with investment decisions. For instance, an investor may wish to avoid inclusion of “sin” stocks such as tobacco, gambling and weapons manufacturers in a portfolio.
Sovereign risk: A form of credit risk in which the borrower is the government of a sovereign nation, rather than a corporation. Over the years, many sovereign governments such as Argentina and Russia have defaulted on sovereign debt.
Standard deviation: A statistical measure of dispersion that is widely used to describe the volatility of an investment asset or portfolio. A higher standard deviation implies greater volatility, or risk.
Tax alpha: The value created in an investment portfolio by using techniques such as tax-loss harvesting to manage and reduce tax liabilities.
Tax loss harvesting: The practice of selling securities in the portfolio at a loss and applying those losses to offset realized taxable capital gains in your portfolio or tax liabilities on ordinary income. This results in reducing current year tax liability.
Time horizon: The time period associated with a particular investment objective such as saving for retirement.
Total return: The rate of return of a portfolio that takes into account both capital appreciation and income.
VIX Index: A measure of implied volatility in the stock market that is calculated on the basis of short-term index options on the S&P 500 Index. A high VIX index signals anxiety and fear in the market and typically occurs after a sharp decline in stock prices. A low VIX index generally follows calm markets and rising prices.
Volatility: A risk measure that uses the dispersion of returns for a security, index or portfolio of assets. Volatility is typically measured by using the standard deviation or variance (square of the standard deviation) between returns of the asset during a given time period. Greater volatility implies higher risk.
Yield curve: The relationship between bond yields and bond time-to-maturity. A so-called normal yield curve, for instance, is upward sloping, representing rising rates with longer maturities.