In this week’s edition of the Investment Corner, we explore a few key risk metrics. The correlation coefficient and performance formula are two you should be familiar with. Financial metrics are not a heavily guarded secret, but deciphering them can require translation!

Mama’s Secret Sauce

At dinner with some friends last night, my wife talked about her ‘secret’ homemade pasta sauce. Her recipe isn’t really a secret, but no, I still can’t share it; however, I must say it is delicious! Much like Mama’s sauce recipe, financial metrics are no secret, but knowing what metrics to use and understanding what they mean can significantly impact how/what you invest in.

In many ways, finance talk can be a different language for many. Don’t worry; our team at Whitaker-Myers Wealth Managers is full of expert translators ready to help whenever you’re ready. We will explore many more key metrics in the future and translate them for all to understand. However, we’re digging into some key risk metrics in today's post. Ready, Set, Go!

Risk Statistics

When measuring risk within a profile or between two assets, two important concepts to familiarize yourself with are the correlation coefficient and the performance equation. These widely used statistical measures provide insight into possible similarities, returns, and unpredictable variability.

Correlation Coefficient:

The correlation coefficient measures how closely two entities or assets are related or the strength of association between the two data sets. It is reported between -1 and +1. The closer the number gets to -1, the less correlated the two entities are, with -1 showing a negative relationship (opposite). On the other hand, as the correlation coefficient reaches +1, the two entities have a similar or positive correlation.

Why does it matter? 

Our team of advisors tracks this metric to create better diversification within your portfolios. This limits the impact that one part of the portfolio can generate a ripple to the rest of the portfolio. In today’s interconnected global society, the individual sectors do not operate in silos. However, the direct impact can be limited when the correlation coefficient is less.

Performance Formula

If you’ve listened to any financial podcasts or talked to your financial advisor, you’ve likely heard the terms alpha and beta when discussing investments. These two metrics, or variables, are a part of the performance formula. This equation utilizes a linear regression analysis to identify correlations between the variables. The variables include:

y = a + bx + u

where,

y = the performance of the fund/stock/portfolio

a = Alpha, excess return compared to the benchmark

b = Beta, measures volatility compared to a benchmark

x = the performance of the benchmark (commonly the S&P500)

u = residual, this variable considers the market's randomness. These are the unexplainable occurrences that happen in which the performance cannot be attributed to alpha or beta metrics. (Investopedia.com)

Alpha measures the positive return in your portfolio compared to the benchmark. When you hear a mutual fund manager yell, “I’ve got alpha,” he’s talking about the difference between the returns from his managed portfolio and their selected benchmark. This is exactly where alpha can get tricky. Last week’s article discussed that not all investments are created equal. Thus, measuring an investment against any index may or may not be appropriate. Having a positive alpha is excellent, and a negative alpha indicates underperformance. Finding the right benchmark with similar assets is crucial to understanding how well your investment is performing and if it’s your turn to yell, “I’ve got alpha!”.

Beta, on the other hand, measures the volatility of the investment compared to the benchmark. It more specifically quantifies how much an investment’s price fluctuates compared to the market. A Beta value of 1 indicates the investment correlates with the benchmark’s movement. A Beta value >1 indicates higher volatility than the market; thus, much larger swings can occur compared to the benchmark.  A Beta <1 shows lower volatility than the market/benchmark.

Take home points:

By now, I hope your eyes haven’t glazed over and you’re still following along.  Here are some key takeaway points to prepare you for the next advisor meeting. Remember:

·        Correlation coefficient - depicts how ‘correlated’ two entities are!

·        Alpha and beta are used to compare and predict returns (though no one can accurately predict returns!)

·        Alpha – Measures positive returns against a benchmark (we all want more alpha!)

·        Beta – Measures Volatility/risk

·        High Alpha, high beta = High reward, high risk

·        High Alpha, Low beta = High reward, low risk

·        Low Alpha, high beta = Low reward, high risk

Overall, the performance formula helps quantify the relationship between two variables and estimate the value of the dependent variable based on the independent variable. The model's accuracy depends on how well the equation captures the true relationship between the variables and how small the error term is.

Talk to your advisor about these variables when reviewing your investments. Align your strategy with your future goals. At Whitaker-Myers Wealth Managers, our advisors all have the heart of a teacher and are fiduciaries here to help.