Posted by Hi everybody, Andre here at the Coach’s Hangout.
If your exam is just around the corner, don’t miss out on this last minute study tip. If the course provides a glossary like the Canadian Securities Course does, give it a quick review and take note of any obscure terms. Take it from me, I’ve created thousands of multiple choice questions throughout my career. And a term like arbitrage makes for a great one. The student either knows it or they don’t. And it’s really easy to come up with three believable, tempting, but wrong answers, which is the hallmark of a great question.
All right, let’s get to it and start earning you some potential marks. Nellie’s friend nicknamed her nervous Nellie, because no matter how much fun they’re having, she always thinks of the terrible what ifs. When it comes to investing, the thought of losing money would definitely keep her up at night. With this in mind, what do you think Nellie would prefer, a high or low beta? Well, what about standard deviation, alpha or sharp ratio? Take five seconds, and think through your answer. Pause the video, if you need a little more time.
Now, if you thought Nellie doesn’t like risk, so she probably wants all of those things to be low, then drum roll please. You’d be wrong, so stay tuned.
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Beta and standard deviation are measures of risk. And therefore a conservative investor would want to keep them low. Beta refers to how a security is expected to react compared to the overall stock market. For example, a beta of one would indicate that the security is expected to move in unison with the market. If a security has a beta of two, that would mean it’s expected to move twice as much as the market. Now, this means up or down, so if the market declines by say 5%, we would expect the security to decline 10%. Nellie wouldn’t like that very much, so she’d prefer a low beta.
Now, standard deviation refers to the security’s volatility in returns. In other words, how much does the return deviate from year to year? The more volatility, the riskier the stock. For example, if a security has a 20% return one year, a negative 10% return the next, followed by an 18% return, it would have a high standard deviation, as compared to a security that has a consistent return every single year. Again, Nellie doesn’t like risk, so she would prefer a low deviation.
Now, alpha refers to how much value the portfolio manager added. For example, if based on the level of risk assumed, the portfolio had an expected return of 10%, but your portfolio manager is a good stock picker and generated a 12% return, within those risks constraints, the manager’s alpha is two.
Look, it doesn’t matter if you’re a conservative or aggressive investor, your portfolio manager adding value to your portfolio is a good thing. So the higher the alpha, the better. And this holds true for Nellie as well.
The Sharpe ratio measures the return per unit of risk accepted. Well, all investors would like the highest return for the level of risk they are assuming, right? I mean, even if Nellie was investing in a treasury bill, she would prefer a 1.5% return over a 1% return. So the higher the Sharpe ratio, the better. Oh, and here’s a great little memory aid. You always want a very Sharpe portfolio manager.
As you can probably tell from this exercise, knowing what a glossary term means is critical. But for certain questions, you’re still going to have to think a little bit when it comes to applying it. Remember, the name of the game is practice, practice, practice. Where you can learn from your mistakes and not make those same mistakes on exam day.
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