Often when looking at a fund managers performance you’ll see three stats, the Alpha, the Beta and the Sharpe Ratio. Here’s the short definition of each:

Alpha – is the measurement of a fund’s actual return and its expected return given its beta. Alpha  is the excess return given the risk taken.

Beta – the beta (β) of a stock or portfolio is a number describing the relation of its returns with that of the financial market as a whole.

Sharpe Ratio – is a measure of the excess return (or Risk Premium) per unit of risk in an investment asset or a trading strategy.

When selecting an investment adviser, hedge fund or some other form of money manager, take the time analyze their track record to ensure they are actually giving you an edge.

The most important indicator of the three is the Sharpe Ratio, the higher the better. To give you an idea of a bench mark, the long term Sharp Ratio for the US Market is 0.40625 (based on a long term return of 10% for the market, a 16% Standard Deviation and a 3.5% rate of risk less return). Therefore, if a fund manager has a rating any lower than that, you may be better off just buying the S&P Index.

Beta shows correlation with the market. For instance, a Beta of 1 means that if the market went up 10% above the risk free rate, then the managers portfolio went up 10% after the risk free rate. A Beta of -1 would conversely mean that with a market up 10% above the risk free rate, the managers portfolio went down 10%. It is also possible to have greater than 1 and -1 Beta’s using leverage.

When looking at Beta’s keep in mind what your other asset holdings are. If you already have a substantial amount of money tied up in securities that are heavily correlated with the overall market, you may want to consider hedging that position with a portfolio manager with a negative Beta, but a good Sharpe Ratio.

And in finally, Alpha, which is an indicator of risk compared to reward.  Alpha less than 0 indicates an investment earned too little considering the risk taken, an Alpha equal to 0 indicates an investment earned a return adequate to the risk taken, and an Alpha of greater than 0 indicates a return that was in excess of the risk taken. Keep in mind, that a money manager can have a great year, but if he took excess risk to do so he can still have an Alpha of < 0.

One note of caution, ensure that when you are reviewing a fund managers returns that they are comparing themselves to the appropriate benchmark, such as the S&P 500, the Dow Jones Industrial Average, or in Canada the S&P TSX Composite Index. Those are the benchmarks of the industry.

In addition, if you’re looking for further reading on either of those three metrics checkout the links below.

http://en.wikipedia.org/wiki/Alpha_%28finance%29

http://en.wikipedia.org/wiki/Beta_%28finance%29

http://en.wikipedia.org/wiki/Sharpe_ratio

“A creative man is motivated by the desire to achieve, not by the desire to beat others.

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Within the world of investing there are two schools of thoughts when it comes to stop losses. Many traders, especially ones with shorter term horizons, prefer to use stop losses to control risk. In a liquid stock, commodity or currency, you can control exactly what your downside is controlling risk in each of your positions, as well as for your portfolio at large. Hence your risk of ruin is greatly reduced. There is always the possibility of your holding gapping, but if you trade in liquid markets that risk is minimal. This is also a more common trait of technical traders.

Conversely, many value investors, such as the all mighty Warren Buffet don’t use stop losses at all. Their view is that if a security drops, even by 30% to 40%, it’s simply an opportunity to buy more at a better price lowering their average cost. The theory goes that if you did your analysis of the fundamentals correctly, there’s no reason to react to “Mr Market’s” irrational offers for your holding. Simply wait until the market recognizes the underlying value and “Mr Market” offers you a more rational price.

This is great if your always right in your analysis, the fundamentals are reported properly and somehow not already priced into the market place. But what if, by some miracle, your actually wrong? You could lose 100% of your money waiting for a rational price from Mr Market, when it really turns out your the one being irrational?

Let’s delve into the numbers. Of all the literature I’ve read on the subject (and yes, I have read the Intelligent Investor), the statistics I found most informative were from a fund located in Arizona called Blackstar Funds. They did a research paper titled The Capitalism Distribution, which investigated returns of stocks from 1983 to 2006. Some key stats from this paper:

– 1 out of 5 stocks lost 75% or more of their value.
– 1 out of 5 stocks returned 300% or more of their value.
– 39% of stocks had a negative return over this period.
– 61% of stocks had a positive return over this period.
– Of the 8000 stocks in the study, the best performing 2000 (25% of all stocks) accounted for all the gains, and the worst performing 6000 (75% of stocks) collectively had returns of 0%.

The stat I find most startling, is if you had somehow managed to miss any of the top 25% stocks from 1983 to 2006, you would have made a return of 0%! Ponder the fact that if you were not properly diversified, concentrated into stocks that you “knew” were going to go up, and sat around waiting for “Mr Market” to eventually come around and see things your way, there’s a 1 in 5 chance you’ll lose 75% of your money and its very probable that you’ll make nothing at all.

Suppose you were in the unfortunate situation above and had managed to miss the top 25% of gainers in the market in this period. Let’s say rather than being convinced that your analysis was infallible, you considered the possibility that you were flat out wrong and set a few top losses. We’ll make them relatively wide, since you are a very confident individual as you have the fortitude to invest in the first place, so for arguments sake we’ll put them at 10%. A few of your stocks hit your stop losses, and although you have to realize a loss (which is very difficult physiologically to do, it has been proven that it’s much easier to keep your loss a “paper loss”, a subject for another blog post), you now have the opportunity to hit the books again, do your research and delve back into the market with another opportunity to find that 25% of winners.

Following this strategy you’ve managed to control your risk and rather than have your capital sit around waiting for something to happen in a loser, you’re out finding other winners minimizing your opportunity costs.

The flip side to this its what’s known as a whipsaw, which is the case where you set your stop losses to 10%, the stock dips to 11% then pops up 25% and you miss the move and consequently swear off stop losses for life. For one, this will happen, if you don’t want it too, stop trading. Two, this in my opinion is not an argument against stop losses, but rather an argument against poorly setting stop losses. If done correctly, this strategy will save you a lot more money that it will cost you. In later posts, I’ll share strategy’s that I’ve used for stop losses, such as volatility stop losses, as well as support/resistant level and others.

In conclusion, why do I use stop losses? Because I don’t want myself or my clients to have a 75% loser in our portfolio’s. And although I’m unbelievably intelligent, I’ve astounded myself to occasionally being wrong, and I’m not about to get into a long, drawn out argument with “Mr Market”.

“We must all suffer one of two things: The pain of discipline or the pain of regret and disappointment.”

This blog is about one thing and one thing only, learning about the stock market to make money in the stock market.

This is not about making money by investing in “ethical” companies, or about striving after a measly 6% returns year to year to year. This is about making cold hard cash legally (hence the stack of $100 bills), while limiting the downside and controlling risk. If you want to save the world after you make that money, that’s your prerogative and very commendable.

I will be exploring all aspects of the market place in Canada, the USA and around the world. I’ll talk a look at terminology, different strategies, make calls on stocks I like and don’t like, do a lot of technical analysis, a bit of fundamental analysis for your entertainment, make book recommendations, tell you what books not to read and respond to your questions/comments. Ideally, this will be a mutually beneficial exchange.

Enjoy your visit and time to start stacking those $100 bills,

“The journey of 1000 miles begins with the first step.”

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