By Xavier Brenner In the investing world, risk and reward are intertwined. The higher the risk, the higher the potential reward. To get a better reading on both, many financial professionals choose to rely on a set of statistical measures to guide their investment decisions.
Covestor manager Robert Sloma, who oversees the Aggressive Stock portfolio, recently delved into the general concept of risk-adjusted return. Broadly speaking, this covers an array of mathematical relationships that compare the returns of portfolios with different risk levels against a benchmark like the S&P 500 Index and Dow Jones Industrial Average. Robert's post stirred interest, so let's lift some of the fog surrounding related financial market concepts that help investors understand risk. Here are five key concepts the money pros watch:
Want an accurate reading of how your investment or portfolio is really doing? A good place to start is alpha, a measure of an investment’s risk-adjusted performance compared to a benchmark, such as the S&P 500. Why does Alpha matter? It's a true indication of what a portfolio manager actually brings to the party. In a rising market, it shows whether your financial adviser is outperforming the broader market or just going along for the ride. How much risk did he or she use to get there? In a declining market, a talented money manager can deliver less-than-average losses. Alpha can measure that, too. A positive alpha of 1.0 means the fund or stock has outperformed its benchmark index by 1 percent. A similar negative alpha shows underperformance of 1 percent.
The Alpha calculation, in addition to benchmark analysis, also takes into account beta, a measure of the volatility or the market risk of an investment compared to the rest of the stock market. Alpha is sometimes called beta-adjusted return. Investors can better compare portfolio managers if they understand the return they generated and the market risk they tolerated to achieve that performance. Take the case of two hypothetical portfolio managers, Josh and Elena. Let's assume, both delivered the same 2% annual return over and above the S&P 500 Index last year, but Josh used a far riskier strategy to get there.