Risk and Return

Real vs. nominal. A nominal increase or decrease is an actual percentage change, without any adjustment for inflation. A real increase or decrease is the change after adjusting for inflation.

Dilution. As a company sells additional shares or compensates employees with stock, existing shareholders see their stake in the company diluted. Dilution also occurs at the macroeconomic level. As new companies spring up, existing corporations—and their shareholders—can see their claim on the economy’s profits diluted. This macroeconomic dilution has been estimated at 2 percentage points a year.

Price-earnings ratio. This is a company’s share price divided by its earnings per share. An example: If a company’s stock is at $60 and its earnings per share are $4, the company’s P/E multiple would be 15.

Dividend yield. To calculate a company’s dividend yield, you divide the annual dividend by its stock price. For instance, if a company pays a dividend of 50 cents every quarter and it has a $40 stock price, you would divide the $2 total annual dividend by $40, giving you a 5% yield.

Book value. On a company’s balance sheet, if you subtract the company’s liabilities from its assets, you get stockholder’s equity, which represents the amount invested in the company through both stock offerings and retained earnings. When stockholder’s equity is computed on a per-share basis, it’s known as book value. Some value investors favor stocks that trade at or below book value.

Beta. This is a measure of how much a stock rises or falls relative to a market index, typically the S&P 500. For instance, if a stock has a beta of 0.85 and the S&P 500 climbs 1%, you would expect the stock to rise 0.85%.

Standard deviation. While beta measures an investment’s volatility relative to a market index, standard deviation measures how much an investment strays from its own average return. For instance, if a stock fund has a 9% average annual return and a standard deviation of six percentage points, that tells you that 68% of the time its annual return should fall between 3% and 15%. This range of returns is equal to one standard deviation. The range for two standard deviations would be 12 percentage points above and below 9% and would cover 95% of annual returns, assuming the fund’s returns were normally distributed.

Correlation coefficients. This is a way of measuring similarities in the performance pattern of two investments. Correlation coefficients range from -1 to +1. If the correlation between two investments is +1, they rise and fall in sync. If it’s zero, there’s no correlation, while a -1 correlation coefficient indicates they move in opposite directions. If you combine investments whose returns aren’t closely correlated, you should find the resulting portfolio less nerve-racking to own. This is the reason many stock investors will add bonds and alternative investments to their portfolio.

Value vs. growth. A growth stock is one that holds out the promise of rapid revenue and earnings increases, while value stocks may have a less promising outlook, but typically they are cheaper based on yardsticks such as price-earnings multiples, price-to-book value and dividend yields. Historically, value stocks have outperformed growth stocks.

Factor investing. Academic studies have attempted to identify which stock market characteristics—or “factors”—are associated with superior returns. Research has found that, historically, superior returns have been delivered by smaller-company stocks, value shares, stocks displaying short-term upward price momentum and stocks of companies with higher gross profitability.

Duration. This is a measure of a bond or bond fund’s sensitivity to interest rate changes. A bond fund with a duration of five years would fall 5% in price if interest rates rose by 1 percentage point and climb 5% if rates declined by 1 percentage point.

Credit risk. When you buy a bond, you take on credit risk, which is the risk that the bond’s issuer will default. This risk is negligible for Treasury bonds and modest for municipal bonds and large corporations. But defaults are a real possibility with so-called junk bonds, which are those that are rated below investment grade by the credit rating agencies.

Covered calls. Investors will sometimes sell call options against the stocks they own. This strategy generates extra income, thanks to the premiums received from the buyers of these options. In return for paying that premium, the buyers have the right to call away the stock at a specified price—which means the options’ sellers could miss out on gains if the stock involved climbs sharply during the life of the option.

Cash investments. These are investments where there’s little or no risk of losing money. Cash investments include savings accounts, bank money-market accounts, money-market mutual funds and certificates of deposit.

Alternative investments. This category encompasses everything from timber to real estate investment trusts to gold stocks to hedge funds. The common element: These are all seen as investments that might fare well when stocks are performing poorly.

Next: Taxes

Previous: Portfolio Building