Learning about Alpha

In the Morningstar report, look for the word Alpha under the MPT Statistics heading.  Alpha is one of the few statistics that mean anything on its own.   Alpha is short for Jensen’s Alpha created by an American economist, Dr. Michael Jensen in 1969.  There is a great deal of economic theory that goes into creating the Alpha. However, all you need to know to use it is this.  If the Alpha is positive, the referenced investment beat its relative index or category.  If it is negative, it is below the benchmark used. By looking at the Morningstar report for the Dodge and Cox Fund, it shows that the Alpha for the fund is 0.31.  Remember that positive numbers are better.  This is not a percentage however it does give you a basis to compare other large capitalized value funds.   An important thing to learn is that you should always check your sources for validity.  For the same three-year time period, on the Yahoo Finance page, the Dodge and Cox Fund has an Alpha of -1.91.  That is a significant difference.  In this circumstance, because of Morningstar’s reputation, I would depend upon their statistics ahead of Yahoo Finance.

So, in the example above, an investor that is willing to accept the risk of a mutual fund that has value oriented stocks from large companies can see that the Dodge and Cox Stock Fund over the past three years beat the average large cap stock mutual fund by 0.31.  This concept works with any investment that supplies the Alpha.  The only change that you may need to be concerned about is if the Alpha calculation uses a different index.  For example, a 0.31 Alpha from a large cap value mutual fund would not be the same as a 0.31 Alpha from a fund that is compared to any other category of mutual fund. 

Learning about Beta

The next term to look at is Beta.  Without getting into the theory and formulas that are used to come up with the Beta, let’s just say that the statistic gives an investor an indication as to how an investment will react in certain market conditions.  Betas can vary depending upon the benchmark that is used in the formula to create it.  Morningstar gives two Betas. Their report uses the Standard & Poors 500 as a benchmark, and the other is called the best fit.  In other words, Morningstar determines the best benchmark that fits the fund.  In the case of the Dodge and Cox Stock Fund, the best fit is the Russell 1000 Value Index.  Below is a table that will help you see when beta can be useful. 

When using any of the risk statistics, remember that all of it is a theory called the Modern Portfolio Theory.  And the fact that the statistics are theories means the assumptions and conclusions are NOT guarantees.     The best use of risk statistics in personal investment planning is to help better understand the risk that investments pose.  Type your paragraph here.

This is how the chart above works.  Let’s take an example of an investment that has a beta that is greater than one.  As indicated in the chart above, investments with a beta greater than one are expected to beat their relative category or index used when the market is going up.  Investments that have a Beta that is greater than one are expected to do worse than the category or index being used when the market is in decline. 

A central point of a Beta is that the category or index being used is always expected to be equal to the number one.  So, if you have an investment that has a Beta of one, its Beta is identical to the category or index.

Learning about R Squared

Next is the term R Squared which is sometimes referred to as the Coefficient of Determination.  R Squared by itself has little predictive value.  There must be an index associated with R Squared to have value.  If you look at the Morningstar Report, you can see that Morningstar uses the S & P 500 as well as the Russell 1000 Value Index.  R Squared is a number between 0 and 1 and usually stated in percentages.  The closer R Squared is to one means the closer the investment will track the index.  If you refer to the accompanying Morningstar report, you can see that the R Squared for the Dodge and Cox Stock Fund relative to the S & P 500 is 82.05%.   R Squared is very valuable when determining how well a mutual fund or ETF tracks to an index.

Learning about Standard Deviation

The next term is Standard Deviation.  This statistic estimates the variability of an investment.  Standard Deviation is usually derived from the historical performance of an investment.  It is easier to define Standard Deviation by looking at two graphs that represent the statistics effects.  Type your paragraph here.

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Six Keys to Understanding Investment Risk

There is so much investment information available that it is difficult to make sense of it all.  When trying to choose investments or determine how they did, many people look at the historical performance of an investment.  They pick the investments with the best performance or determine the success of their investment by direct comparison to past performance.  Direct comparison of past performance alone does not give the full picture of an investment’s risk.  Just to be clear when I refer to risk, I am talking about an investment losing value.  And in the end losing value is losing money.  There are other methods of evaluating investments based upon an individual’s tolerance for risk.  However, evaluating investments by risk preference takes some specific financial expertise.    Here are six keys to understanding some of the more commonly available information on investment selection and monitoring by risk characteristics plus how to apply it. 

When you look at investment reports from Morningstar, Yahoo, Bloomberg or just about any of the news sources that provide data on risk, there is little or no explanation.  So what does it all mean?  There are six risk measurement statistics that are the most common. Alpha, Beta, R Squared, Standard Deviation, the Sharpe Ratio and the Treynor Ratio.  A surprising fact about these six statistics is that the same statistic may differ from news source to news source.  The reason is that some of the sources, like Yahoo, may use a benchmark they are referring to as a category.  That benchmark may be another mutual fund, an average of certain funds, an ETF or another index.    Other sites like Morningstar may use a different benchmark in their calculation.  So, there may be some variation from source to source on the same day.  And there will certainly be changes from day to day because of market changes.  

In this guide, I’ll give you a recommendation as to what circumstance each statistic may be useful.  Let’s look at a sample report from Morningstar and Yahoo Finance (Morningstar, 2017; Yahoo Finance, 2017).  Both sample reports accompany this post. The investment example used in the report is a mutual fund called the Dodge and Cox Stock Fund.  If you have the capability to bring the reports up to multiple screens or print them out, it will help you to see my references more clearly. 

Standard Deviation itself is determined based on an investment’s historical variability.  There are two sets of parameters within which Standard Deviation falls.  In the example above σ is the representation of Standard Deviation.  If the Standard Deviation of an investment is 10%, then this investment may be either as much as 10% over or 10% below the E (r ) or expected return 68% of the time.  Another 16% of the time the investment will be outside of the one Standard Deviation.  Morningstar is only reporting within one Standard Deviation which means that only 68% of a fund’s possible variability is being considered.  This is important to know because the Standard Deviation that Morningstar and most news sources report do not take into consideration the statistics’ illustration of worst case scenarios.   

You can see more of the downside risk of an investment by viewing the graph below. This graph shows that 95 % of the time the investment can be as much as 20% above or 20% below the average return.  And 2.5% of the time it can be either higher than two times the Standard Deviation or 2.5% of the time the investment can be below two times the Standard Deviation.  

Standard Deviation can be a good indicator of the volatility to expect from an investment, however, do not let the first number reported lull you into a sense of unfounded safety.  The Standard Deviation of your portfolio may give you an idea of how vulnerable you may be to market corrections but remember it is not a guaranteed limit to variability.  In analyzing the Standard Deviation of any investment, it is critical to pay attention to the outliers.  Ask yourself what you will do in the event that your investments have large losses.    Just because a hypothetical analysis predicts only a 2.5 % chance of the worst circumstance happening does not insulate you from losses.  

Learning about the Sharpe Ratio

The Sharpe Ratio is a comparison statistic.  Unless you know the Sharpe Ratio for the index or category that is used to create the Sharpe Ratio, the number by itself is pointless.  In the example of the Dodge and Cox Fund, the Sharpe Ratio is 0.68.  Additionally, Morningstar page gives the Sharpe Ratio for the S & P 500 at .92 and the Sharpe Ratio of the Large Cap Value Category at 0.61.  So, you can tell that the Dodge and Cox Stock Fund performed better than the average large cap mutual fund and slightly below the S & P 500 index.  One final note on the Sharpe Ratio, the way that it is designed it will only work with diversified portfolios.  That means that it will not work with individual securities or focused investment portfolios.

Learning about the Treynor Ratio

The Treynor Ratio, on the other hand, is more flexible because of the design of the formula from which it is derived.  It can be used to analyze fully diversified portfolios, focused investment portfolios or individual securities.  Additionally, the Treynor Ratio is also a comparison ratio.  Without knowing the Treynor Ratio of the relative index, category or sector; the Treynor Ratio is useless.  The Morningstar page for the Dodge and Cox Fund states the Treynor Ratio for the fund as 7.34, and the Large Cap Stock Category’s Treynor Ratio is 6.43.  The most important conclusion to gather from analyzing the Treynor Ratio for the Dodge and Cox Fund is that the fund beat its relative category. 

These are the conclusions that can be drawn for the use of these six statistics. 

1. Alpha is a very literal statistic.  Positive Alphas are good and negative Alphas are bad.

2. Beta gives an investor an indication as to how an investment will react in certain market conditions.

3. R Squared lets an investor know how well their investment tracked to an index, category, or ETF. 

4. Standard Deviation gives an investor a general indication of how the price of an investment may vary. 

5. The Sharpe Ratio lets an investor know how a diversified investment performed compared to its index.

6. The Treynor Ratio lets an investor know how any investment has performed compared to its relative index or category. 

There is no specific strategy to using risk statistics.  What an investment advisor does is looks at the statistics and sees which ones give the best indicators to help an investor invest within their risk tolerance and help them obtain the financial goals that they have for themselves, their family and business.  

Posted by: Van Richards

Van is the founder of Advice4Retirement and Advice4LifeInsurance you can contact him at van@advice4retirement.com Follow on Twitter @VanRichards or Facebook at https://www.facebook.com/Advice4Retirement/ and https://www.facebook.com/advice4lifeinsurance/


Morningstar, Inc. (2017, July 28). Dodge & Cox Stock Fund (DODGX) fund risk and Morningstar rating. Retrieved from http://performance.morningstar.com/fund/ratings-risk.action?t=DODGX®ion=usa&culture=en_US

Woerheide, W. (2016). Fundamentals of investments for financial planning (8th ed.). Bryn Mawr, PA: The American College Press.

Yahoo Finance. (2017, July 28). Summary for Dodge & Cox Stock Fund -. Retrieved July 27, 2017, from https://finance.yahoo.com/quote/DODGX/risk?p=DODGXType your paragraph here.