Don't be fooled into thinking that your success as a stock investor is measured by the increase in price of your portfolio's holdings. What you really want is to make the most money with the least risk. The profits you make are not only price increases, you have to add the money that securities distribute regularly in the form of stock dividends and bond coupons. Moreover, there are fees and taxes to deduct from those gross profits, which depend on your investment decisions. Besides, we also need to factor in the risks involved, because a risky investment that provides modest gains is not as good as a conservative one that earns the same amount.
Total return and volatility
Gross profit, which is price increase plus distributions, is called total return (the return of an investment is its profit). Publications that inform total return for individual assets don't include taxes, fees and risk, but it is quite a useful measure as long as we keep in mind that those other factors have to be considered separately. Many publications overlook them, especially those that are advertising frequent trading. They might, for example, praise the results of a certain big-turnover portfolio, without mentioning its poor tax efficiency and the large costs that so many trading commissions add up to.
As we said, total return is a good measure of how much money you made, as long as you consider your particular fees and taxes somewhere. What about the "with the least risk" part? Risk is often measured as how much the return varies around an average (expected) value. This is called volatility. To give an example, lets compare a savings account with a stock investment. Money saved in a saving account will grow at around a 3.5% per year. Some years it might grow a little less, a bit more during others, but the invested value will always be quite close to the expected value based on the approximately-3.5% rate (unless something remotely-possible happens, like the bankruptcy of the bank). Variation around the average value, or volatility, is pretty low. Stock investments can vary quite much. As we said before, its historical profitability is of around an 8%, but it is not unlikely that it rises or drops a 20% in one year. It is therefore much more volatile. This implies more risk, because assets may lose a significant portion of their value anytime, which wouldn't happen with an investment with little volatility such as a certificate of deposit or savings account.
Thus, in the world of investments, the terms volatility is frequently used as a synonym for risk. One way to measure volatility, and consequently risk, is through what statisticians call the standard deviation.
Benchmarking
To recap, we can measure gross profits through total returns and we can measure volatility, or risk, through standard deviations. Investors sometimes want to compare these measures to market averages (benchmarks), to know if an investment manager is performing particularly well. That is where the concepts of alpha and beta appear in the investment practice. Beta is a measure of the volatility of a security relative to the whole market. If calculations based on past performance result in a beta of 1, it means the security was as volatile as the benchmark. One lower than 1 means it performed better in regards to risk (it was less volatile) and one higher signifies it showed higher risk. Alpha measures profitability (total return) relative to a benchmark of similar volatility. Thus, positive alpha means the investment has gained more than it was expected given its volatility.
In future articles we will elaborate on these and other more complex measures of performance, some of which integrate the concepts of profit margin, volatility and benchmarking. For the time being, just keep in mind that price increase is not a good measure of performance, you should watch total return instead, remembering that the total return that is informed for individual assets doesn't include fees and taxes, which have to be considered separately. Neither does it include information about risk or comparisons with the market, therefore a good past performance in regards to total return means the investment made money, but it doesn't imply that its manager did a particularly good job.
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