Learning the language of portfolio construction

> Asset allocation. The mandate of any portfolio is to contain the balance of assets that best suits the needs of the investor. The holdings may involve a host of assets, such as domestic and international stocks and bonds, real estate and cash. The right mix varies with wealth and changing personal situation, and tends to require adjustment as the client gets older. Risk also plays a major role: a younger client with a long career ahead can usually take more risk than someone nearing retirement who is looking for a steady income. (See pages D4 and D6-D7.)

> Benchmarking. The returns on the various investments held within a portfolio can shift erratically, particularly with short-term market conditions. Many advisors compare the longer-term performance of a portfolio against well-known market indices, or benchmarks, that track the broader performance of stocks and bonds in a given market. A portfolio statement may, for example, compare the client’s asset performance with the S&P/TSX composite index. (See page D5.)

> Correlation. A measurement for seeing how two assets or variables move in relation to each other. Correlation is used in a portfolio to see if the values of two securities tend to rise and fall closely together (positive correlation) or veer in opposite directions (negative). The advisor may also gauge the movement of a security within a portfolio against its industry rivals or a subindex. (See page D5.)

> Dividend yield. This is the dividend paid on a share divided by a stock’s current market price. A stock now trading at $10 that pays $1 in annual dividends, for example, has a dividend yield of 10%. While many corporate securities pay no dividends, advisors measure the dividend yield on stocks that do, because the regular payments have an overall effect on the total price of the shares being held.

> Moving average. Popular charts measure the average price fluctuations of stocks over intervals, such as 50 or 200 days. The average closing price for a stock over a given period is placed on the chart. Over time, the curve that forms indicates the long-term price trends of the stock vs the latest price changes. A current price that begins to move below the moving average indicates a potential weakness in price. The opposite is indicated when the current price rises above the chart average.

> Price/book ratio. This formula compares a stock’s current price with its book value, which is total assets minus intangible assets and total liabilities. The ratio is best used to compare companies within one industry, as the ratio varies from sector to sector. In mutual funds, the ratio is based on the weighted average of all stocks in the fund portfolio. The ratio is best used with other tools because many companies carry assets such as real estate on their books at the purchase price rather than the current market price.

> Price/earnings ratio. Perhaps the ratio best known to investors, it divides a stock price by its earnings per share for a one-year period. If a stock is selling for $10 and is earning $1 a share, for instance, its P/E ratio is 10. Mutual funds use a ratio based on a weighted average of all P/Es held in the fund. Generally, a stock’s P/E ratio that is higher than that of the overall market indicates investors are paying a premium in the expectation of higher future earnings and a rising stock.

> Price/earnings/growth ratio. This ratio helps indicate whether a stock may be under- or overvalued. The stock’s price/earnings ratio is divided by its forecasted earnings growth rate. A fairly valued stock would have a PEG of 1.0, as its current P/E and future earnings growth rate would be equal. A ratio of less than 1.0 could hint that the stock is undervalued.

> Price/sales ratio. This ratio compares a share price with a company’s sales for each share, by dividing total revenue by shares outstanding or by dividing a stock’s market capitalization by its total revenue. The ratio is often used to value companies that lack a solid history of positive earnings. It is never negative, but low ratios indicate low profit margins.

@page_break@> Quick ratio. This ratio measures a firm’s ability to meet its short-term financial obligations. The total liquid current assets (cash, accounts receivable and marketable securities) are divided by current liabilities. This ratio is similar to a current ratio, but doesn’t include inventory in assets. A company is usually considered healthy if the quick ratio is at least 1.0.

> Rebalancing. The asset allocation within a portfolio must be fine-tuned regularly so the investor’s original goals can be fully achieved and risk can be properly managed. What happens, over time, is that the original allocation among equities, bonds and cash goes off course because of the different performance of each element. A portfolio that was created to hold 50% equities, for example, could hold 65% equities if stocks performed better than bonds in the short term. Some stocks would be sold and the funds put into bonds or held in cash to help restore the balance. (See page D8.)

> Return on investment. ROI indicates management’s performance and is calculated by dividing earnings by total assets. It is a broader measure than return on equity (ROE) because assets include debt. In general, two companies with similar sales and earnings may look like they performed the same, yet the one that required less investment capital would be run better.

> Risk tolerance. The pursuit of gains in the total value of a portfolio depends on how much risk the client is prepared to take. Advisors get the proper feel for the client’s risk tolerance by going through the individual’s finances and long-term goals. As a generalization, someone young can afford more risk than someone nearing retirement, but that’s not always the case. A young couple putting together college funds for their children may be as averse to risk as a grandparent. The risk tolerance level will change with the age, wealth and lifestyle of each client. (See page D4.)

> Sharpe ratio. Is an investment worth the risk that’s probably involved? American economist William Sharpe won a Nobel Prize for creating a test to help all investors answer this vital question. His Sharpe ratio divides an investment’s excess return above the guaranteed return of the current 90-day T-bill rate by its “standard deviation,” an indicator of volatility (see next glossary term). The higher the number that results, the better the investment’s historical risk-adjusted performance. (A useful calculator for the ratio can be found at www.moneychimp.com/articles/risk/portfolio.htm).

> Standard deviation. This yardstick measures the historical volatility in the performance of a single security, mutual fund or portfolio, usually by calculating monthly returns over 36 months. In essence, it indicates how much a price varies from its moving average. The results tend to be calculated for most investment products on an annual basis. A security with a high standard deviation has a lot of variation in its monthly returns, often indicating downside risk. IE