Risk term definitions

Alpha, beta, and R-squared are components of Modern Portfolio Theory (MPT), which is a standard financial and academic method for assessing the risk of a fund, relative to a benchmark. A mutual fund's alpha and beta are calculated in relation to a market index, and each fund is linked to an appropriate index based on its investment category.

Morningstar Risk - Visit Morningstar to learn more about Morningstar Risk.

Alpha - A measure of selection risk (also known as residual risk) of a mutual fund in relation to the market. A positive alpha is the extra return awarded to the investor for taking a risk, instead of accepting the market return. For example, an alpha of 0.4 means the fund outperformed the market-based return estimate by 0.4%. An alpha of -0.6 means a fund's monthly return was 0.6% less than would have been predicted from the change in the market alone.

Beta -  The measure of any fund's or stock's risk in relation to the market. A beta of 0.7 means the fund's total return is likely to move up or down 70% of the market change; 1.3 means total return is likely to move up or down 30% more than the market. Beta is referred to as an index of the systematic risk due to general market conditions that cannot be diversified away.

R-Squared - R-squared ranges from 0 to 100 and reflects the percentage of a fund's movements that are explained by movements in its benchmark index. An R-squared of 100 means that all movements of a fund are completely explained by movements in the index.

Conversely, a low R-squared indicates that very few of the fund's movements are explained by movements in its benchmark index. Thus, R-squared can be used to determine the significance of a particular beta or alpha (the higher the R-squared, the more significant alpha and beta).

Standard Deviation - Standard deviation is a statistical measure of the range of a fund's performance, and is reported as an annual number. When a fund has a high standard deviation, its range of performance has been very wide, indicating that there is a greater potential for volatility.

(Approximately 68.3% of the time (2 of 3 occurrences), the total returns of any given fund are expected to differ from its mean total return by no more than plus or minus the standard deviation figure. About 95.4% of the time (19 of 20 occurrences), a fund's total returns should be within a range of plus or minus two times the standard deviation from its mean.)

Sharpe Ratio - A measure of a fund's excess return relative to the total variability of the fund's holdings. The higher the Sharpe ratio, the better the fund's historical risk-adjusted performance.

Treynor Ratio - A measure of the excess return per unit of risk, where excess return is defined as the difference between the portfolio's return and the risk-free rate of return over the same evaluation period and where the unit of risk is the portfolio's beta.


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