GLOSSARY
401(k) plan A “defined contribution” employee pension plan in which participants contribute a pretax amount (possibly matched—up to a percentage—by the employer) and choose among investment choices offered by the plan.
403(b) plan Similar to a 401(k) plan but offered to employees of educational and nonprofit organizations.
Accredited investor “An accredited investor can be an individual or an institution. An individual accredited investor is one who has a net worth of at least $1 million or has had income of at least $200,000 for each of the last two years (or joint income with a spouse of $300,000).” See www.sec.gov/answers/accred.htm for details.
Active management Investment managers who pick stocks (or bonds in the case of bond funds) to try to beat market averages.
Alpha The percentage by which an investment manager beats a stock market average after adjustment for risk.
Asset allocation The percentages, adding to 100%, by which an investment portfolio is divided among major asset classes such as domestic stocks, foreign stocks, bonds, and real estate.
Asset-liability models Pertains principally to pension funds: probabilistic modeling of the future liabilities of the fund—that is, the value of the obligation to pay future pensions—as compared with the future assets of the fund.
Assets (investment assets) The portion of total funds that are available to invest in investment vehicles such as stocks and bonds.
Asymmetric fees A type of performance fee for asset managers where the manager is rewarded for overperformance without being charged a penalty for underperformance.
Backfill bias The bias introduced into a database of hedge fund performance when funds that have had above-average performance add their historical data to the database—that is, they “backfill” it—only after they decide that it was good enough.
Backtest Running a simulation of an investment strategy using stock (or bond) market data for a historical time period to see how it would have performed over that period.
Basis point A hundredth of a percent.
Behavioral economics/behavioral finance The study of how people make economic and financial decisions, given that they do not always act rationally.
Beta The extent to which a portfolio of risky securities of a certain type (such as domestic stocks) is effectively “leveraged”—that is, the extent to which the portfolio carries risk greater than (or less than) the capitalization-weighted average of all securities in the category. Beta = 1 if the risk is the same as that of the weighted average.
Bias The tendency for a statistical sample from a population to be unrepresentative of the population as a whole. For example, databases of hedge funds are unrepresentative of the population of all hedge funds, because the databases contain numerous biases.
Bond A form of security in which the capital provided by the investor is repaid with interest in fixed amounts on a fixed schedule over a fixed time period (usually interest is paid semiannually and the principal is repaid at the end of the time period).
Book value Roughly speaking, the total of the company’s assets—its desks, its chairs, its buildings, its machinery, and so on—valued individually and added together.
Brokerage A firm that is licensed to buy or sell securities, though large brokerages perform many other functions as well.
Buy-and-hold A strategy of buying a portfolio of securities and holding them for a long time, without any further trades.
Call option An option to buy a specified security (the “underlying”) at a specified future time (the “expiration date”) at a specified price (the “strike price” or “exercise price”). See also Option.
Capital asset pricing model The theoretical model introduced by Nobelist William F. Sharpe and others, saying that the expected rate of return on a security (or portfolio of securities), in excess of the risk-free rate (such as that of a Treasury note), is proportional to the portion of the volatility of the security (or portfolio) that is correlated with the market as a whole.
Capital gains The increase in price over time of a security (or portfolio of securities). Capital gains are “realized” if the security (or securities) is sold, thereby incurring a tax liability in a taxable portfolio. Gains are “unrealized” if the security (or securities) is not yet sold.
Capitalization-weighting Refers to the weighting of the securities in a portfolio or market index (i.e., a hypothetical portfolio). The portfolio or index is capitalization-weighted if the weight of each security in the portfolio is proportional to the total value of its shares outstanding in the market. See also Equal weighting.
CAPM. See Capital asset pricing model.
Commissions (trading commissions) Payments to brokers to execute trades.
Consultant (in the institutional investment context) A consultant to institutional investors who helps to design and track the investment portfolio and choose managers for that portfolio, and sometimes helps to align assets with liabilities.
Correlation (coefficient) A statistical measure of the extent to which two variables vary in the same direction or in opposite directions. The correlation coefficient ranges from an extreme of +1 (for moving together in the same direction in lockstep) to the opposite extreme of -1 (for moving together in opposite directions in lockstep). A value of 0 means no correlation between the two movements.
Covariance Covariance is proportional to the correlation coefficient but is not scaled to be between -1 and +1.
Data mining The practice of performing undisciplined, repeated data studies in an attempt to find patterns in historical data. The danger is that it will uncover patterns that are merely random results, indicative of no inherent cause or design and of no value in predicting future patterns.
Day trading The practice of frequent intraday trading of individual stocks. Day trading is in general a losing strategy because it generates substantial commission costs even at low commission rates.
Debt For a company, the portion of corporate capital that has been financed by issuing bonds or other fixed income, as opposed to the equity portion obtained by selling shares of stock.
Debt/equity ratio For a corporation, the ratio of the value of the portion of corporate capital obtained by issuing debt obligations such as bonds and other fixed income, to the value of the portion obtained by issuing shares of stock.
Defined-benefit pension plan A pension plan for the benefit of retirees in which the amount of retirees’ future benefits is fixed, and the sponsor is obligated to contribute to the pension plan sufficient amounts to ensure that those fixed benefits will be realized.
Defined-contribution pension plan A pension plan in which contributions by employer and employees are fixed while the amounts of future retiree benefits aren’t predetermined but are whatever results from the growth of the contributions through investment.
Directed brokerage A method of payment for incidental services provided by a brokerage firm, such as research studies, in which payment is in the form of an agreement to use a certain amount of that firm’s brokerage services. Also called “soft dollars.”
Discount broker As opposed to a full-service broker, a broker who provides no advice or research but merely executes securities trades as directed by the customer, for a lower commission than a full-service broker.
Discount rate The annual percentage by which future dollars must be discounted to arrive at their equivalent in present-day dollars. For example, if the discount rate is 5%, then $1.05 in one year is worth $1 now.
Diversification Reduction in the risk of fluctuation in the value of a portfolio, also called “volatility” or “variability,” by investing in a large number of securities. Maximum diversification is achieved with a capitalization-weighted portfolio of all market securities.
Dividends Discretionary cash distributions paid out of earnings by a corporation to holders of shares of its stock.
Dollar-cost averaging A practice of making regular periodic investments in stocks over a period of time.
Dollar-weighted rate of return The rate of return on investment taking into account the amounts added or withdrawn from the investment during the time period (also called the internal rate of return).
Dow (Dow Jones Industrial Average) A composite index of the prices of 30 large company stocks chosen by the Dow Jones Company, weighted by their share prices.
Earnings The profits earned by a corporation; corporate revenues after the deduction of costs and expenses.
Efficient frontier A theoretical curved line on the graph of portfolio return versus risk, representing the portfolio with the highest expected return at each level of risk (as computed using Markowitz’s mean-variance optimization methodology).
Efficient market theory The theory that the market prices securities efficiently—that is, that market prices reflect all available information.
Endowment funds Institutional investment funds owned by nonprofit organizations such as universities and foundations.
Equal weighting The weighting of the securities in a portfolio or market index (i.e., a hypothetical portfolio). The portfolio or index is equal-weighted if the weight of every security in the portfolio is the same—that is, if an equal dollar amount of every security is owned by the portfolio. See also capitalization weighting.
Equity A form of security (also called a share, or shares, of stock) in which the investor takes a percentage ownership of a company in return for his or her investment. Therefore, the capital provided by the investor to the company is repaid by the dividends that are paid out as a portion of the earnings of the company, or by the sale of the investor’s ownership at some future time. In comparison with the stream of payouts to the investor from a conventional bond, which are fixed, the payouts to the equity investor are varying and uncertain.
Equity-linked contracts A form of investment contract in which a security and an option are combined in such a way as to give the investor a combination of an equity-linked return (i.e., the value of the investor’s investment goes up if the value of the underlying equity security goes up), while the investor is also guaranteed a specified minimum return over a given time period.
ETF. See Exchange-traded fund.
Exchange-traded fund (ETF) A mutual fund (often an index fund) that is structured in such a way as to mimic a security—it can be bought or sold at any time of day, unlike a mutual fund which can usually be bought or sold only once a day. ETF index funds may, under certain circumstances, be lower in cost than ordinary mutual funds.
Expense ratio The ratio of the annual expenses of a mutual fund (exclusive of trading costs and front-end or back-end loads) to the value of the fund.
Factor model A model used to construct portfolios with certain risk characteristics, or to track specific indexes.
Financial planner (or Financial advisor) An advisor to individuals on investments and usually on other aspects of an individual’s finances, such as taxes, insurance, and estate planning. See also www.sec.gov/answers/finplan.htm.
Fixed income Securities that offer a fixed or steady stream of payouts over time in return for an initial investment. See also Bond.
Full-service broker A broker who offers investment research and advice as well as the service of buying and selling securities.
Fund of funds A fund in which an investor can invest that allocates its assets among other funds, adding an additional fee for the service of selecting and packaging the funds into one.
Fundamental indexing A way of automating the picking of stocks by eliminating the “expert” and using a simple algorithm instead. Fundamental indexing algorithmically “tilts” the portfolio, usually toward value stocks because value stocks have often performed better in the past.
Gains. See Capital gains.
Growth stocks Stocks in companies that are expected to have high future earnings growth rates and therefore, as opposed to value stocks, have high price-to-earnings and price-to-book value ratios.
Hedge funds Any mutual fund-like pooled funds that are unregulated or relatively unregulated because their investors are limited in number and kind (see Accredited investor), and are therefore presumably “sophisticated” and not needing government oversight. See also www.sec.gov/answers/hedge.htm.
Hedging Any method of using securities or (more commonly) derivative securities to provide insurance against the risk of loss in a portfolio of securities. Some hedge funds use hedging, some do not.
Incentive fee. See Performance incentive fee.
Index fund A fund that includes securities only according to a predetermined formula dictating the proportion of the securities in the portfolio, without regard to the current or past characteristics of the companies whose shares are owned. True index funds have very low expense ratios because they don’t pay anyone to analyze and choose securities for inclusion.
Institutional investors Investors that are entities such as corporate pension funds or nonprofit organization endowment funds.
Institutions. See Institutional investors.
Investment advisor “Someone who receives compensation for giving individually tailored advice to a specific person on investing in stocks, bonds, or mutual funds.” See also www.sec.gov/answers/invadv.htm.
Investment assets. See Assets.
Investment managers Companies that select and invest portfolios of securities for clients (also called “money managers”). Can be mutual fund managers or managers of separately managed accounts, such as for institutional investors or high-net-worth individual investors. Investment advisors and consultants often (for a fee, of course) select and recommend investment managers to investors. Investment management firms are among the most profitable, and most consistently profitable, firms in all of industry—in spite of the fact that on average they do not beat an ultra-low-cost, buy-and-hold portfolio. Similarly, investment advisors and consultants exhibit no ability to select investment managers who will outperform a buy-and-hold strategy.
Investment performance Generally means the risk-adjusted rate of return on investment.
Least-squares fit See Regression analysis.
Leverage The extent to which an investment is financed by borrowing.
Liquidity The ease and timeliness with which a security can be sold.
Load A one-time fee for purchase or sale of a mutual fund, either a front-end load or a back-end load.
Long-short equities A strategy of buying stocks that an investment manager believes will do better than the market average while simultaneously “shorting” stocks (borrowing them in order to sell them) that the manager believes will do worse than the market average. If the manager buys and sells equal dollar amounts, then in the unlikely event that the manager is correct in both these beliefs, he or she will do well no matter whether the market average goes up or down.
Market average The investment performance of a hypothetical portfolio containing all marketable stocks, or a specific subset of all marketable stocks (e.g., U.S. domestic stocks), usually capitalization-weighted but sometimes equal-weighted or weighted by the price per share (as in the Dow).
Mean-variance optimization An optimization algorithm proposed by Harry Markowitz in which security (or asset class) weightings within a portfolio of securities are derived in such a way as to maximize the expected return of the portfolio for a given level of variability (or standard deviation) of periodic returns. Application of the method stumbles on the fact that accurate prospective values for the inputs can’t be obtained.
Modern portfolio theory (MPT) The body of mathematical theories of investment, generally including Markowitz’s mean-variance analysis and the Sharpe et al. capital asset pricing model.
Money managers. See Investment managers.
MPT. See Modern portfolio theory.
Mutual fund “A company that pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments, or other securities.” See also www.sec.gov/answers/mutfund.htm.
Option A transaction reserving to the buyer of the option the right—for a price—to make a specified future purchase, or a specified future sale, at a specified future price, and within a specified future time period or at a specified future time.
Passive management The practice of investing a portfolio of securities according to a formula that dictates the makeup of the portfolio, without regard to the characteristics of the companies underlying the securities; as opposed to active management, which attempts to pick securities based on the characteristics of the companies that issued them.
Pension funds Funds sponsored by corporations or governments dedicated to providing retirement and other benefits to employees.
Performance fee. See Performance incentive fee.
Performance incentive fee A fee paid to an investment manager that depends on the rate of return earned over a time period (usually a year) by the manager. A common performance incentive fee is 20% of gains. Because the manager reaps fees in case of gains but returns nothing to the investor in case of losses, performance fees are called “asymmetric.” “Asymmetric” performance incentive fees (fees charged on gains but not rebated on losses) aren’t allowed for mutual funds but are allowed for hedge funds.
Portfolio optimization See Mean-variance optimization.
Price/earnings ratio The ratio of the price per share of a stock to the earnings per share; can be different depending on the time period over which the earnings are calculated (or projected) and the definition of earnings.
Rate of return on investment The percentage by which an investment grows (positive) or shrinks (negative) over a specific time period. See also time-weighted rate of return and dollar-weighted rate of return.
Rationality A vague term applying to assumed investor characteristics, usually interpreted to mean, minimally, that investors prefer a higher return on investment to a lower return, and a lower risk to a higher risk.
Real Estate Investment Trusts (REITs) “Entities that invest in different kinds of real estate or real estate related assets, including shopping centers, office buildings, hotels, and mortgages secured by real estate.” See also www.sec.gov/answers/reits.htm.
Regression analysis The simplest statistical method of choice for pum-meling data to see if there are any patterns in the data. Also known in elementary mathematics classes as “least-squares fit.”
Regression toward the mean A tendency for a wandering random variable to eventually move back toward its average value.
REITs. See Real Estate Investment Trusts.
Return. See Rate of return on investment.
Risk assessment A routine procedure applied by investment advisors usually involving a brief questionnaire to categorize an investor-client according to how much investment risk the client is able or willing to assume.
Risk premium The increase in expected annual percentage return on a risky investment in excess of the return on a (virtually) riskless investment such as U.S. Treasury bills.
Risk-adjusted performance The rate of return on an investment, adjusted for the risk of the investment. For example, if the risk of an investment of $100 is leveraged 2-to-1 by borrowing $100, thus making an investment of $200, and returns 10% on the original $100, its risk-adjusted return is reduced by a factor of 2, resulting in a risk-adjusted performance of 5%. Several methods have been proposed for expressing risk-adjusted performance.
S&P 500. See Standard & Poor’s 500.
Security In investment, a contract or document showing ownership of a future contingent cash flow stream received in exchange for the investment of capital; usually a stock or a bond.
Self-selection bias Self-selection bias arises in any situation in which individuals select themselves into a group.
Socially responsible investments Equity investments that are selected in part by screening the issuing companies for certain corporate practices that are deemed socially responsible by the selector.
Standard & Poor’s 500 A capitalization-weighted index of 500 of the largest U.S. companies’ stock prices; currently comprises over 70% of the total capitalization of all U.S. companies.
Standard deviation A statistical measure of the variation or dispersion of a set of numbers; in investments, a measure of the variation or dispersion of periodic rates of return (e.g., daily or monthly)—that is, the volatility or variability of returns.
Stock. See Equity.
Stock market Any marketplace in which shares of stock are bought and sold.
Style allocation Usually, the percentages—adding to 100 percent—by which the equity component of an investment portfolio is divided among major equity asset classes such as large growth stocks, large value stocks, small growth stocks, small value stocks, international stocks, and emerging-market stocks; can also apply to the categories of bonds and real estate. See also Asset allocation.
Style drift A manager’s portfolio exhibits style drift if it starts to look different from the style the manager was supposed to manage.
Survivorship bias Bias in a database of investment funds over a historical time period due to the fact that data for funds that didn’t exist at the end of the time period aren’t included in earlier periods.
Target-date funds Mutual funds that change their asset allocation as the investor ages, generally investing a higher proportion in stocks when the investor is young and a lower proportion in stocks as the investor ages.
Time-weighted rate of return The rate of return on investment over a specific time period if the investor made no contributions or withdrawals from that investment.
TIPS (Treasury Inflation-Protected Securities) Securities issued by the U.S. Treasury similar to ordinary government bonds except that their principal values and interest payments are adjusted for inflation. See also www.treasurydirect.gov/indiv/products/tips_glance.htm.
Trading volume The number of shares traded per day.
Transaction cost The cost of buying or selling a stock or a bond, including brokerage commissions. When institutions (e.g., mutual fund companies, pension funds, investments banks, and hedge funds) make large trades, costs may include losses due to a change in the market because of the trade.
Turnover The percentage of the investments in a portfolio that is bought or sold annually. “Buy-and-hold” and passively managed portfolios generally have low turnover, while actively managed portfolios generally have higher turnover.
Value stocks Stocks in companies that have low price-to-earnings and price-to-book value ratios.
Variance Statistically, the square of the standard deviation; a measure of the variability of periodic rates of return.
Volatility The variability, or degree of fluctuation, of periodic rates of return, usually measured statistically by standard deviation or variance, and considered a proxy for risk.