Glossary

We thank the students in Tucker Balch’s online course Computational Investing, Part 1, for their assistance in compiling this glossary.

Active Management: Investment management that intends to choose specific investments that will outperform their asset class. Contrast with passive management, or indexing. Active management incurs higher costs than indexing, a drag on performance that causes very few active managers to outperform benchmark indexes over long periods.

Alpha: A measure of an investment style’s incremental return relative to simply holding a diversified portfolio. All active management, such as hedge funds, strives for “positive alpha.”

Arbitrage: Buying a near-identical asset in one market and selling it in a different market at a higher price. This opportunity to profit will usually be exploited by profit-seeking investors, who, through their buying and selling, will “arbitrage away” price disparities.

(Arithmetical) Average rate of return: An asset’s return on investment averaged over multiple periods. If the S&P 500 returned 10 percent 3 years ago, 7 percent 2 years ago, and 1 percent last year, the average annual rate of return over the 3 years is (10 + 7 + 1 = 18) ÷ 3 = 6 percent per year. Strictly speaking, this is an arithmetic average: summing the returns and dividing the sum by the number of years. A superior approach that accounts for the effects of compounding is a geometric average, the compound annual growth rate (CAGR).

Asset allocation: Specifying the desired fraction of a portfolio to be invested in a given class of assets. For example, a “balanced” allocation might be 50 percent equities and 50 percent bonds. Allocations can change gradually, as the investor’s time horizon shortens, or quickly to respond to changes in relative valuations.

AUM: Assets under management. Wealth managers, including hedge funds, charge fees on the basis of the amount of clients’ assets they manage.

Bear market: A sustained period in which the general direction of the price of a class of assets is downward. For contrast, see correction, rally, and bull market.

Beta: A measure of a financial instrument’s (like a stock) volatility relative to the broader universe of similar instruments. For example, a stock’s beta is the ratio of its standard deviation to the standard deviation of a broad stock index such as the S&P 500. A beta of <1.0 is associated with a low-volatility stock such as an electric utility. A beta of >1.0 might mean a small-cap or growth stock, where investors overreact to both good and bad news. A beta of 1.0 implies a stock with volatility equal to the index.

Bollinger Bands: Range around an asset’s price on a given day that reflects one standard deviation above and below that price.

Bonds: An investment that pays the buyer a stream of coupon payments at a specified interest rate. Also known as a “fixed income” investment. The price of bonds moves inversely with their interest rate.

Bull market: A sustained period of upward movement in the price of an asset class. Bull markets can be punctuated by corrections.

Capital Assets Pricing Model (CAPM): Framework that distinguishes investment returns of an asset between market returns (beta) and asset-specific returns (alpha).

Capital gain: The part of an asset’s total return that occurs because of changes in its price, as opposed to from dividend payments. Capital gains are sometimes taxed at favorable (lower) rates compared with ordinary income such as wage income.

Compound annual growth rate (CAGR): Annual growth based on the geometric average, not the arithmetic average. Using the example from “average growth rate,” the CAGR would be [(1.10) × (1.07) × (1.01) = 1.1877] raised to the one-third power (to reflect 3 years of compounding) = 1.05933, or a 5.933 percent CAGR. In this example, the result is very close to the arithmetic mean of 6 percent, but with larger growth rates or more years, the arithmetic and geometric means can diverge significantly. CAGRs are the superior way to compute an asset’s long-term return on investment (ROI). For a simple way to roughly compute CAGRs in your head, see also the Rule of 72.

Compounding: The exponential effect of persistent growth. One hundred dollars deposited into a mutual fund that grows at a 5 percent rate of compounding will be worth $105 at the end of the first year, $110.25 after the second year, $121.62 after the fifth year, and $155.13 after the 10th year. Higher rates will compound even faster. Compounding can make the job of saving a given amount much easier if the saver starts early enough, because its effects are magnified over time.

Constraint: Limitation on flexibility that restricts the optimum solution. See also optimization.

Correction: An interruption in a bull market or rally in which an asset class’s prices fall (by convention, by at least 10 percent). Bull and bear markets need not reflect a uniform rise or fall in asset prices; they can be interrupted by corrections (downward) or rallies (upward).

Correlation: A measure of the relationship between two variables. In the context of investing, correlations are used to represent the degree to which asset class A (say, stocks) moves in tandem with asset class B (say, bonds). If A rises whenever B rises, the two assets have a high positive correlation. Investors seek to hold assets that move in opposite directions, that is, that have a high negative correlation, so that when A falls, B rises and compensates for (hedges against) the effects of the drop in A. This smoothes out fluctuations in the combined portfolio value of A and B together. Correlations are measured on a scale from −1.0 (perfect negative correlation—A always rises when B falls, and vice versa) to 1.0 (perfect positive correlation). See also decoupling.

Cumulative rate of return: The accumulated returns achieved by an asset over a specified period. If $1,000 in 2005 grows to $2,000 by 2010, it achieved a 100 percent cumulative growth rate for those 5 years. Its compound annual growth rate (CAGR) would be 14.9 percent per year.

Deviation, standard: See Standard deviation and variance. A measure of an asset price’s volatility.

Diversification: Avoiding putting all your “eggs” in only one “basket.” Diversification of an individual’s investment portfolio means holding several classes of assets (not only stocks or only bonds), as well as multiple securities in the class (e.g., owning stock shares in several different companies). Commercial transactions may diversify the currency used (e.g., including euros or yen as well as dollars). Diversification smoothes out fluctuations in value—as long as the assets that are added fluctuate in response to different causes than the original ones. See also correlation. For a contrasting view, see fundamental law.

Dividend: A portion of a corporation’s earnings paid to its stockholders. A company’s “dividend payout rate” is that proportion. Stocks can be compared by their dividend yields (dollars of dividend per share divided by the purchase price of the share). Many academic studies have found that the vast majority of stocks’ total return comes from dividends.

Efficient frontier: In a scatter graph showing the risk and returns of various asset classes, the efficient frontier displays the subset for which there are no superior assets—where higher return requires taking higher risk. It is a generally curved frontier above and to the left of the majority of assets.

Equities: Common stocks, so called because their owner holds a share of the company’s “stockholder’s equity” (net worth).

ETFs: Exchange-traded funds; mutual fund-like investment pools that invest in a particular class of security, such as stocks of companies located in a particular country or a specific industrial sector. When they originated, ETFs were passively managed funds with commensurately low costs. As their numbers have proliferated, ETFs are becoming less diversified and more expensive.

Fundamental Law: In the 1980s, Richard Grinold introduced what he calls the Fundamental Law of Active Investing, described nicely in his book co-written with Ronald Kahn. (See “Suggestions for Further Reading.”) We paraphrase his law as follows:

Skill is a measure of how well a manager transforms information about an equity into an accurate prediction of future return, and breadth represents the number of investment decisions (trades) the manager makes each year.

Gross domestic product (GDP): The total goods and services produced in an economy. The U.S. GDP, at nearly $15 trillion, is about 25 percent of world GDP. GDP per capita is a measure of the standard of living: a nation’s GDP divided by the size of its population. The U.S. GDP per capita is among the highest in the world. Gross national product (GNP) is GDP plus the net effect of the balance of payments (surplus or deficit).

Gross margin: One definition of margin also known as “profit.” Gross margin is revenues minus only those costs directly related to the production of the company’s product, such as raw materials. Net margin, or the “bottom line,” also deducts companywide costs such as overhead. Margins are often expressed as a percentage of company revenues to make them comparable across companies.

Hedge fund: Private pool of capital that invests the funds of institutions or accredited individual investors. Hedge funds are lightly regulated and relatively unconstrained in their investment discretion. See Chapter 1 for further description.

High frequency trading (HFT): Computer-driven trading that may earn very small profits per trade, but compensates with speed and volume.

Indexing: Purchasing a group of investments that collectively represent the asset class to which they belong. Usually the constituents are those in an index. For example, the S&P 500 index is shares in the top 500 American public companies by market capitalization, often used as an index to reflect broad stock market movements. An index strategy benchmarked to the S&P 500 would simply buy shares in all of the companies in the S&P 500, in the same proportion they occur in the index. Index strategies do not try to “beat” the market but simply match the market. Index funds compete on the basis of (low) cost, not performance.

Inflation: An increase in the general level of prices, usually measured by the consumer price index. Put another way, an indication that the supply of money is growing faster than demand for it (i.e., than overall economic activity). This oversupply of money causes it to decline in value. This is reflected in higher prices for the things money buys, that is, inflation. As Nobel Prize–winning economist Milton Friedman noted, “Inflation is always and everywhere a monetary phenomenon” (emphasis added).

Leverage: The use of other people’s money to purchase an asset. An example is a homeowner who secures a mortgage from a bank to buy a house. Because the bank has loaned funds (as opposed to purchasing an equity share of the house), the borrower experiences the full effect of price movements in the asset. When the asset’s price is rising, the borrower enjoys the full gain, but the same is true if the asset price falls. The recent recession was caused largely because major banks had used massive leverage—sometimes borrowing more than $30 for every dollar of equity they had—to purchase assets such as mortgage-backed securities (MBSs). When the MBSs fell in price because of rising defaults, the banks suffered magnified losses because of the extent of their leverage. The late 2000s recession was long because households were obliged to deleverage (a.k.a. “unwind”) their heavily indebted positions.

Long/short: A hedging strategy that takes a long position in one asset and a short position in another. For example, a fund might be convinced that, say, Exxon had good prospects, and buy XOM; and at the same time, it would hedge against a general decline in the oil industry by going short on oil ETF. A.W. Jones’ original “hedged fund” pioneered long/short strategies. Many hedge funds fall between the poles of “long only” and “short only” with such mixed strategies.

Marginal tax rate: The tax rate collected on your next dollar of income (i.e., “at the margin”). High marginal rates are believed to discourage the earning of additional income, because the earner keeps little of their new earnings.

Market cap: Short for “market capitalization” or the current value stock markets place on an entire company. If a company has one million shares outstanding that traded today at $6 per share, it has a market cap of $6 million. Companies are categorized as “large cap,” “midcap,” and “small cap.” There is no standard definition of the breakpoints between the categories, but a rough rule of thumb is above $10 billion, $1 billion to 10 billion, and below $1 billion, respectively. “Microcaps,” as the name implies, are even smaller than small caps with a market cap in the millions, not billions.

Modern portfolio theory (MPT): Principles of portfolio design based on each component’s return, risk, and correlation with each other component. MPT demonstrates that if the components of a portfolio have low or negative mutual correlations, it may be possible to reduce risk without sacrificing return.

Mutual fund: Pool of investors’ capital collectively invested in a designated portfolio. Mutual funds are convenient means for small investors to achieve diversification. There are more than 10,000 mutual funds extant, investing in many different asset classes. The largest number invest in stocks, bonds, or both (known as balanced funds). Mutual funds are regulated under the Investment Company Act of 1940, far more strictly than hedge funds.

Negative correlation: See correlation.

Negative real interest rates: See real interest rates.

Nominal: In general, “nominal,” such as a “nominal return on an investment,” means not adjusted for inflation. “Real” reflects that adjustment. If your certificate of deposit (CD) offers a 2 percent coupon but inflation is 3 percent, you’ve earned a +2 percent nominal return but a -1 percent real return.

Nominal interest rates: Rates quoted in the market, unadjusted for inflation. Nominal rates have two components: inflation (the change in the is Consumer Price Index (CPI) and the real interest rate.

Optimization: Choosing the combination of decision variables that produces the best outcome in light of constraints. Generally an optimum is achieved by maximizing or minimizing an objective function (measure of achievement of a goal). Portfolio optimization entails choosing the proportions of the portfolio devoted to each of a set of assets.

Options: Contracts that give the purchaser the right to buy or sell an asset (such as 100 shares of stock) at a specified price. “Call” options give the right to buy, and “put” options the right to sell. Someone might buy a call option if they believe the price of the stock will go higher than the strike price. Options have an expiration date, so if the stock does not rise above the strike price, the option will expire worthless (known as being “out of the money”), and the seller of the call will not be obliged to sell the shares (the shares will not be “called away”). A seller of a call option who owns the asset to be called is selling a “covered” call; if they do not own it, they’ve sold a “naked call.” Covered options are far less risky than naked ones.

Passive management: See indexing.

Portfolio: A collection of assets combined to achieve diversification.

Positive correlation: See correlation.

Rally: Temporary interruption in the downward movement of an asset class’s prices. Rallies are the mirror image of corrections. It is not uncommon for bull markets to be punctuated by corrections and bear markets by rallies.

Real: Adjusted for inflation, by subtracting the inflation rate. See also nominal.

Real interest rates: Nominal interest rates adjusted for inflation (by subtracting it). If a certificate of deposit (CD) pays a 3 percent nominal rate, but inflation is 2 percent, investors receive only 1 percent of added purchasing power through interest payments. In other words, the CD’s real interest rate is 1 percent. Real interest rates can be negative: If the same CD offers a nominal 3 percent and inflation is 5 percent, it pays a negative 2 percent real rate. Economists assess central bank monetary policy by computing real interest rates. Negative real rates are economically stimulative, while positive rates are restrictive. In 2009, the Fed kept short-term nominal rates near zero, while inflation was between 1 and 2 percent. So real rates were roughly negative 1 percent, a stimulative policy. Investors’ great concern in late 2009 and early 2010 was that the Fed would stimulate for too long.

Rebalancing: The act of selling portfolio components whose current weight exceeds its asset allocation target, and using the funds to purchase assets whose weight is below its target. Implicitly, the investor is “selling high” and “buying low” without any specific timing or foreknowledge. Rebalancing has been found to modestly increase long-term returns, mainly by selling overbought assets before they fall and buying oversold assets before they rise. Generally, rebalancing should be an occasional process, either scheduled (say, annually) or whenever asset weights fall outside of bands around their targets.

Return on investment (ROI): The excess an investor receives over the amount he invested. In general, higher-risk investments must offer higher average returns to attract investment. In an efficient market, each investment’s risk-adjusted return should be about the same.

Risk-adjusted return: An investment’s return, adjusting for variability in that return, typically by dividing by its standard deviation. The Sharpe ratio (named after Nobelist William Sharpe) makes this computation.

Rule of 72: A simple rule of thumb that provides an approximation of the effects of compounding sufficient to double the value of an asset: If you know its average growth rate in percent, divide that number (omitting the percent sign) into the number 72 to get the number of periods needed for the asset to double in value. For example, an asset that grows at 6 percent per year will require 12 years (72 divided by 6) to double. At 8 percent per year, it will need 9 years (72 divided by 8) to double. The Rule of 72 is not exact but is a reasonable approximation of the complicated math of compounding. It is also useful for increases of more than a factor of 2. For example, a factor of 8 increase is 2 to the third power, so the Rule of 72 could be applied 3 times over.

Savings: The portion of an individual’s income that is not consumed. Savings are the source of all investment, so a nation with a low savings rate must either borrow from other sources or reduce investment.

Short selling: Borrowing and selling an asset in anticipation of a drop in its price so that you can buy it back at the new lower price to meet your obligation to your lender. Short selling of bonds by those concerned about a nation’s fiscal policy can put great pressure on its bond prices or its currency. This technique is often used by disgruntled bond vigilantes.

Sovereign wealth funds: Investment funds maintained by the governments of countries that run budget surpluses, usually because the nation exports more than it imports (e.g., oil-exporting countries). These funds act much like other institutional investors, except that their client is, directly or indirectly, a national government. This leads to concerns that these funds’ capital will be deployed in pursuit of foreign policy goals, not commercial goals.

Spread: The difference between interest rates of two different fixed income instruments (e.g., corporate versus treasury bonds); used as an indicator of how investors view the comparative riskiness of the two instruments. In late 2008, spreads between most other types of bonds and treasuries widened greatly, as investors who were spooked by market turmoil rushed to the safety of treasuries, bidding down their yields and bidding up the yields of other issues. (Remember that bond yields vary inversely with bond prices.) See also yield curve.

Standard deviation: A measure of an asset price’s volatility. Computed as the square root of each time period’s squared deviations from the mean price for all periods. See also variance.

Sterilization: When a central bank prevents its increase in the money supply from depreciating the value of the currency. Commonly, this is done by simultaneously issuing currency and bonds, in the expectation that investors will buy the bonds and thereby take currency out of circulation.

Stocks: Claims on a portion of the assets of a company. Also known as equities, because common stock owners own a portion of the company’s equity: its net worth. Preferred stockholders also own a share of company equity, but they take precedence over common stockholders if the company is liquidated (i.e., its assets are sold of).

Total return: The sum of an investor’s returns stemming from dividends received, plus gains in the price of the asset (capital gains). Over the past 80 or more years, the total return of stocks has averaged in the high single digits in percent. But in the decade of the 2000s, stocks’ total return was close to zero, because the decade was bookended by bear markets.

Variance: The sum of an asset price’s deviation each time period, squared, from the mean for all time periods. The square root of variance is standard deviation.

Volatility: Variation in the price of an asset or in its growth rate. Investors, of course, are happy with volatility on the upside but less so with downside volatility. For stocks, the most common measure of volatility is beta.

Yield curve: The profile of interest rates offered by bonds of different maturities. Generally, investors demand higher yields to lend their money for longer periods, so the yield curve is upward sloping. An inversion of the yield curve—where short-maturity bonds offer higher yields than long maturities—has been an excellent predictor of recession, because it implies that investors expect rates to fall in the future. This usually happens when demand for capital dries up because firms see declining sales and no longer wish to make investments in adding productive capacity.