Few years ago, when I started studying investments I used to get confused between the terminologies used in investments arena. In this post, I will explain various investment terminologies which are used frequently which will enhance your understanding and will help you make more informed decisions.
- Market Risk: You have read it in numerous Mutual Fund advertisements- “Investments are subject to market risk”. Lets try to decode this.Risks can be classified in two types: Risks that are present in that particular instrument and Risks that are prevailing throughout the market.
For example: Apple, a giant in area of technology getting bust because of its internal reasons (though it is not that likely), but still its a risk. This risk only effects instruments (like shares) of that particular company.
Now, lets take the economic meltdown in China. It shows the risk prevailing in the whole market no matter what company we are talking about. This is Market risk a.k.a Systematic risk. One can’t diversify these risks. Though you can reduce these risk by having exposure in international markets, but still there is market risk of global economic turmoil.
- Beta: Such a ill-defined term. In every field it has different meanings. Being an ex-science student, in maths majors its a variable, in biology its a type of brain wave, in chemistry it has to do with radioactive radiations and a long list of its interpretations. Talking of finance, it refers to “sensitivity” (that’s the word I can come up with which best describes the soul of this term). It measures the reaction of a stock (or any instrument) as compared to a unit action in benchmark.
For example: Starbucks (SBUX.OQ) shares have a beta of 0.84. It means it moves 0.84% in the direction of index when the NASDAQ Composite (index) moves 1%.
Beta <1 means it is a less reactive stock and has lesser risk and lesser reward than benchmark.
- Alpha: Again, a greek term with numerous meanings. In finance, it is related with “excess return for a given risk”. It is an indicator of outperformance of funds. Investors track this for mutual funds and other funds to compare between the fund manager’s ability to generate more return for a certain level of risk.A greater alpha denotes that the fund has generated more return than other funds by taking same risk.
For example: (Alpha > 1) means the fund has beaten the benchmark risk-return ratio, if less it depict that the fund is an under performer (you might want to stay away from these and invest from out performers).
- Portfolio Diversification: “Never keep all eggs in one basket” – Very famous quote in finance. In finance, we always talk about optimising risk-return for lesser risk and greater return to prevent under utilisation of resources. Every economy/sector in economy/company operating in an economy has some advantages and some disadvantages and we as owners of our portfolios want to take advantage of everything (addition) and offset disadvantages (subtraction). So, we often invest in multiple instruments to eliminate (reduce) individual disadvantages and add the individual advantages.
For example: When currency is depreciating, exporting businesses tend to profit but importing business tend to lose. Smaller companies tend to be more volatile (High Beta) whereas large companies are more stable. So, taking example of these two scenarios- A portfolio with even a small portion of small companies can improve the overall portfolio performance as compared to a full large-cap company portfolio and at lower risks as compared to full small cap portfolio. And in scenario of currency volatility balanced exposure to both sectors can nullify the downside risk if the risks were adverse.
- Index: You must be thinking what is an Index. An Index is a value considering a collection of shares (any instrument) which serves as an indicator of whole market performance. It serves as a benchmark for other securities (instruments which are traded in exchanges) for comparative analysis.
For example: BSE SENSEX in BSE, India. SGX NIFTY in Singapore, HANG SENG in Hong Kong
- Ex-Dividend: It is a term which investors come across after quarterly/annual results of a company (if they perform well :p). Dividend is like a reward an investor gets for his investments in the company by purchasing its shares. When the dividend is paid to investors, that amount is reduced from the company’s reserves which ultimately decreases the value of the company. Because of this the value of shares usually decrease by the amount of dividend. This reduction in value of shares in called ‘going ex-dividend’.
- Fundamental Analysis: Before investing, one must research upon the robustness of the business. In this analysis, investors go through the financial statements of the company, research upon the quality of management team, check upon the governance practices, checking the viability and growth prospects of the company’s business for next few years.
- Technical Analysis: It is very useful for traders trading in financial instruments. Estimations are made by analysing price of instrument and volume of trade. Determining the levels one can take risk and benefits associated with the risk. Usually, it is not very effective for long-term investments as it considers trends in short-medium term. In long-run, we expect trend, factors of production, management etc will change.