The ABC of Investing

This article contains terms often used in investing. It is alphabetical, but in 2 levels rather than 1 level. For example Sovereign Bond is at 2nd level under Bond, not at 1st level. So just search the page for the term you want to find (Control-F). Bold means the word is listed in this dictionary.

This page only lists investing related terms. It does not list economy or business terms (unless they are related to investing). It does not list finance or accounting terms (unless they are related to investing). It does not list banking or insurance terms (unless they are related to investing).

  1. Accrued Interest: a portion of the next coupon, up to today. For example, if the next coupon is $150,000 on 1st Nov 2015, the last coupon was 1st May 2015, and today is 1st July 2015, then the accrued interest is 61/184 x $150,000 = $49,728.26.
  2. Average Life: is the average number of years for which each dollar of the bond principal remains outstanding. It is the total of (number of years from today to each payment x percentage of principal being paid on each payment). Also known as Weighted Average Life.
  3. Asset Allocation: dividing a portfolio into several asset classes, e.g. shares, bonds, property, commodity and cash, in order to maximise the return and minimize the risk. Then divide shares further into large cap, small cap, US, Europe, Asia, value, growth, income; and divide the bonds further into government, IG corporate, HY corporate, short duration, long duration, emerging market, developed market, etc.
  4. Asset Class: a group of securities with similar characteristics. The top 5 asset classes are: equity, fixed income, cash equivalent, commodity and property. See also: Instrument.
  5. Asset Backed Security (ABS): a financial instrument with income payment coming from a pool of underlying assets such as loans, mortgages, leases, credit cards, company receivables and royalties. The repayment of the loans is used to pay the bond holder as interest/coupon.
    1. Mortgage Backed Security (MBS): a bond backed (collateralised) by a pool of mortgages. The monthly mortgage payments from the homeowners are passed through to the bond holders, so the bond holders receive both the principal and the interest every month.
    2. Collateralised Debt Obligation (CDO): a derivative instrument backed (collateralised) by a combination of (loans, bonds and other debt instruments). The monthly loan payments from the debtor and the coupon payments from the bonds are paid to the CDO holders. The combination of (loans, bonds and other debt instruments) are grouped into tranches e.g. senior tranche, junior tranche and each tranche is sold as a separate CDO. A CDO with senior tranche contains loans and bonds with high credit rating, and is paid first, but has low interest rate. A CDO with junior tranche contains loans and bonds with low credit rating, and is paid last, but has high interest rate.
    3. An ABS which is not an MBS or a CDO for example backed by credit cards or company receivables are also called ABS. So there are 2 meanings of ABS.
  6. Benchmark: an index, a combination of indexes, or a cash instrument, against which the performance of a fund is measured against. Examples of companies that create indexes are: MSCI, Barclays, S&P and FTSE.
  7. Bond: a financial instrument issued a company or a government as a way to borrow money.
    1. Corporate Bond: a bond issued by a limited company.
    2. Sovereign Bond: a bond issued by a national government. Also known as Government Bond.
    3. Municipal Bond: a bond issued by a regional government.
    4. Supranational Bond: a bond issued by an organisation formed by several countries’ government, such as European Union, World Bank, European Bank for Reconstruction and Development, European Investment Bank, Asian Development Bank, and International Monetary Fund.
    5. Index Linked Bond: a bond which the coupon payment and the principal payment are adjusted in line with the Retail Price Index movement.
    6. Permanent Interest Bearing Shares (PIBS): fixed income securities issued by building societies. It is like a preference share but for building society instead of a limited company. PIBS has no redemption date.
    7. Perpetual Bond: a bond without a maturity date. It is more like equity than a bond, the opposite of Preference Share
  8. Black Monday: Monday 19th October 1987 when the stock markets crashed.
  9. Cash Equivalents: cash in bank, treasury bills, short term gilts, certificate of deposit, commercial papers, and money market instruments.
  10. Charges and Fees: amount of money that a fund manager, a broker or a platform provider charges an investor for investing in a fund or a share. For a fund they are:
    1. Account Administration Charges: the various charges we pay to the platform provider for things we are doing with our account, e.g. opening an account, closing an account, withdrawing money from our account, putting money into our account, collecting dividend or interest payments, and transferring our account to another provider.
    2. Annual Management Charge: the amount we pay to the platform provider once a year (or once a month) for each account we have, for having an account with them. The amount usually depends on how much funds we invest in that account.
    3. Dealing Charge: the amount we pay to the platform provider every time we buy or sell a fund.
    4. Initial Charge: the amount we pay to the fund manager on the day we invest in the fund. It is a % of the amount invested. Sometimes the initial charge is implemented as a Spread, which is the difference between the purchase price and sell price.
    5. Ongoing Charges Figure (OCF): total of all charges we pay for a year to a fund manager when we invest in their fund. This includes the cost of running the fund, (management cost, accounting, valuation), custodian fees, trustee/depositary fees, regulator fees, registrar fees, legal adviser’s fees. UCITS funds must quote an OCF.
    6. Performance Fee: the amount we pay to the fund manager when they perform better than the benchmark.
    7. Total Expense Ratio (TER): like OCF, but including the performance fees paid over the past year. Non UCITS funds quote TER instead of OCF.
    8. For a share the charges are:
    9. Dealing Charge: the amount that the broker takes every time we buy or sell shares.
    10. Stamp Duty: the 5% government tax on purchases of UK shares (0.2% for French shares and 0.12% for Italian shares)
  11. Collateral:
    1. In banking: an asset which is provided as a security, when a company borrows money from a bank. For example: a property. If the company cannot repay the debt, the bank takes possession of the asset, and sells the asset to pay the outstanding amount.
    2. In swap: cash or government bond provided to a counterparty, to reduce credit exposure in a swap. In a swap trade, one party has negative MtM (mark to market), whilst the other party has a positive MtM. The latter needs to provide collateral to the former, to reduce the credit exposure.
  12. Convexity: a graph between the bond yield and the bond price.
  13. Corporate Action: an event in a public company that affect shares or bonds of the company.
    1. Bonus Issue: the company creates (issues) new shares and gives them to the shareholders for free. The share price will be reduced accordingly, so that the value of holding is does not change.
    2. Bonus Rights: the company gives rights to existing shareholders. Rights provide shareholders the privilege to buy shares at a discounted price.
    3. Consolidation: the company replaces the shares with less number of shares which have higher values. For example: every 2 shares are replaced with 1 new share. If we have 800 shares with market price of 60p, the company will replace our shares with 400 new shares and the market price will be 120p (can be more or less than this depending on the market). The opposite of consolidation is stock split (subdivision).
    4. Conversion: the company offers the holders of Convertible Bonds to convert their bonds to shares, with N to M ratio. For example: 5 to 2, i.e. 5 bonds become 2 shares. The shares are new issues so it lowers the share price.
    5. Delisting: the company informs all shareholders that it will no longer be listed on the stock exchange. This Corporate Action is probably the worse one. The shareholders will have difficult time selling their shares because nobody wants to buy them.
    6. Demerger: the company is split into 2 companies. Company A is split into A and B. And then A is renamed into C. We had 1000 shares of A, price = $8. We receive 200 shares of B, price = $3. We still hold 1000 shares of C, but the price is now lower, say $7.50. Also known as Spin-off.
    7. Dividend: the company pays cash to distribute the profit to the shareholders. The correct term is Cash Dividend, because there is another one called Stock Dividend where the shareholder receives shares instead of cash. The shares can be another company’s shares.
    8. Liquidation: the company went bankrupt due to debt and liabilities. A receiver will be selling the company’s asset to pay for the debt. The liquidation process can take a few years. Also known as Bankruptcy.
    9. Name Change: the company changes name. There is no impact to the number of shares or the price of the shares.
    10. Open Offer: the company invites existing shareholders to buy new shares at a fixed price, usually lower than the market price. The quantity offered is proportional to the number of shares we have. For example 1 every 10. So if we have 1000 shares we are entitled to buy 100 new shares.
    11. Redemption: the company (the issuer) pays the bonds we hold (nominal + accrued interest) at the call date. Redemption is more widely known as Call.
    12. Return of Capital: the company pays an amount in cash to the shareholders, proportional to the value of their shares. It is similar to dividend payment. Also known as Special Dividend. Return of Capital will lower the share price, proportionally.
    13. Rights Issue: the company offers existing shareholders the rights to buy new shares at a discounted price. The offer is proportional to the amount of shares we hold. Rights can be sold and bought in the market.
    14. Scheme of Arrangement: a company trying to buy all the shares in a target company. The buyer and the seller agreed on a price in court. The agreement is called the scheme of arrangement. If 75% of the shareholder in the target company agrees, then the scheme goes ahead.
    15. Stock Split (Subdivision): 1 share is divided into several shares with lower value. For example: 1 share is divided into 3 shares. The value decreases to 1/3 of the original value.
    16. Takeover: a company trying to buy all the shares in a target company by making an offer to existing shareholders to buy the shares at a certain price (or combination of cash and share). The shareholders can accept the offer before a certain date. Once the bidding company holds 50% of the shares, it has control of the target company. The existing shareholders will then receive the proceeds in the form of cash and shares. Also known as Merger.
    17. Tender Offer: the company offers to buy back some of the shares we hold at a fixed price. Also known as Repurchase Offer.
    18. Warrants Exercise: on certain dates warrant holders can convert their warrant into ordinary shares at certain price.
  14. Coupon: the “interest” of a bond
  15. Country of risk: the most dominant country affecting the value of a position. Usually it is a) the country of domicile of the issuer, b) the main securities exchange where the issuer is listed, or c) the country where the issuer’s main revenue is from.
  16. Crossing: a broker matches the buy and sell orders on the same security from different clients and offset them off. If a match is not found internally, crossing can also be done externally using publicly available networks such as POSIT and Instinet.
  17. Custodian: a bank which holds for safe keeping the shares, bonds and other securities that a fund manager holds in a fund. The custodian also settles the trades, collects the dividends and coupons, administer corporate actions, maintain bank accounts, and perform FX
  18. Depositary/Trustee: a company that holds the fund’s underlying asset in trust and make sure that the fund manager keeps the investment objectives. Difference between a depositary and a custodian: the latter only keeps but does not own; while the former keeps and owns the asset. See also: registrar, custodian.
  19. Derivative instrument: a financial instrument which value is determined from an underlying instrument. Included in derivatives are: options, futures, swaps and forwards.
    1. Underlying instrument: a financial instrument referred to by a derivative instrument. An underlying can be a bond, a stock, an index, a rate.
    2. Exchange-traded derivative (ETD): a derivative listed on a securities exchange.
    3. Over-the-counter (OTC) derivative: a derivative contract created directly between two parties, outside the securities exchange.
  20. Discretionary fund manager: a fund manager that builds a custom portfolio for a client.
  21. Distribution fund: a fund that generates income, usually using a mix of 60% bonds and 40% equity income.
  22. Duration: the weighted average maturity of the future cash flows. It reflects the sensitivity of the bond’s price to interest rate changes.
    1. Modified Duration: the change in the bond’s price if the interest rate changes by 1%.
    2. Effective Duration: like Modified Duration but taking into account that the interest rate change will affect the expected cash flows. It is used for bonds with embedded options, such as call and put.
    3. Spread Duration: the change in the bond’s price if the spread move by 1%.
  23. Embedded Options: the right for the issuer or the holder to change the agreement in the bond, such as to call, to put, to convert it into equity, to change the cumulative payout, and to change the voting rights.
    1. Callable Bond: a bond which the issuer can buy the bond back (aka “to call the bond”)
    2. Puttable Bond: a bond which the holder can sell the bond to the issuer (aka “to put the bond”)
    3. Convertible Bond: a bond which the issuer can convert it into the shares in the company.
  24. Emerging vs Developed Markets: a way of classifying country of risk according the size and liquidity of their stock markets and bond markets.
    1. Developed Markets: countries with high per capita income, well-developed stock markets, FX markets, derivative markets, open to foreign ownership, good brokerage services. They are (according to MSCI): Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, UK, US.
    2. Emerging Markets: countries where the equity and bond markets are mature enough and the economy is market oriented and developing quickly. They are (according to MSCI): Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Russia, Qatar, South Africa, Taiwan, Thailand, Turkey, UAE.
    3. Frontier Markets: countries with small securities exchange, but investible. They are (according to MSCI): Argentina, Bahrain, Bangladesh, Bulgaria, Croatia, Estonia, Jordan, Kazakhstan, Kenya, Kuwait, Lebanon, Lithuania, Mauritius, Morocco, Nigeria, Oman, Pakistan, Romania, Serbia, Slovenia, Sri Lanka, Tunisia, Vietnam.
  25. ESG (Environmental, Social and Governance): three factors affecting sustainability of an investment, because they affect the potential future performance of the company (issuer).
  26. ETF (Exchange Traded Fund): a security in a stock exchange which tracks an index. The price changes fluidly so it is more like a share than a fund. The index can consist of equity, bonds, or commodity.
  27. Equity: a security which is a share of ownership in a company.
    1. Cyclical Stock: shares which goes up and down in sync with the economy growth and recession. Industry sectors for cyclical stocks are: financials (banks and insurance), mining, construction, retail, transport, and manufacturing. See also: Sector.
    2. Defensive Stock: shares which is not affected by the economy growth and recession. Industry sectors for defensive stocks are: utilities, consumer staples, tobacco, food, and healthcare.
  28. Exposure: the amount of risk in the market. For a plain debt or equity instrument say a bond or stock, the exposure is the same as the market value. But for a derivative, say an option, the value of the option itself (the market value if we sell it today) is small, while the exposure (the amount that we are “risking” or “betting” against) is large.
  29. Factsheet: a monthly two-pager document containing basic fund info such as fund name, fund manager, fund objective, NAV, fund size, lunch date, base currency, benchmark, performance, risk, top 10 holdings, asset allocation.
  30. Fiduciary: a person or a company who has control over the fund’s assets or the trust’s assets. Practically speaking it is the asset manager, or the pension fund.
  31. Financial Market: a place where people buy and sell securities.
    1. Capital Market: trades securities with long maturities (> 1 year) issued by companies and government to raise money, in the form of shares, bonds or loans. Primary Market: buying the shares offered to the public for the first time (Initial Public Offering) or new issue of bonds. Secondary Market: buying and selling existing shares or bonds.
      1. Stock Market: trades equity / shares, mostly in a Stock Exchange.
      2. Debt Market: trades bonds and Mostly OTC.
    2. Money Market: trades securities with short maturities (usually a few days, max of 1 year) such as certificate of deposit (CD)
    3. Derivative Market: trades options, futures, swaps and forwards.
    4. Currency Market. trades currency pairs. The biggest Also known as FX Market or Foreign Exchange Market.
    5. Commodity market: trades precious metal such as gold and silver, energy such as oil and power, or agricultural products such as wheat and corn.
  32. Financial Ratio: a number divided by another number which shows the financial condition of a company.
    1. Earnings per share (EPS): net income divided by number of shares.
    2. Price-to-book ratio (P/B): share price divided by ((asset minus liabilities) divided by the number of shares).
    3. Price-to-earnings ratio (P/E): share price divided by EPS.
    4. Cyclically Adjusted Price Earnings ratio (CAPE): share price divided by sum of (EPS in the last 10 years x Inflation Factor)/10. Also known as the Shiller Ratio or P/E 10 Ratio.
  33. Fixed Income: security with fixed periodic interest such as bonds. See also: Bond.
    1. Government Bonds: sovereign bonds, supranational bonds, agency bonds, regional bonds (municipal), index-linked bonds. Treasuries (US), gilts (UK), bunds (German).
    2. Corporate Bonds: financials/non-financials, cyclical/non-cyclical, investment grade/high yield aka IG Corp and HY Corp.
    3. Convertible Bonds: bonds that can be converted into equity.
    4. Certificate of Deposits: money in the bank for a fixed term, earning interest
    5. Preference Share: a share which the holder receives a fixed dividend (called coupon). The fixed dividend must be paid before the ordinary shares. Also known as Preferred Stock. It does not have a voting right. It is subject to interest rate risk. It is subject to credit risk. It is more of a bond than equity.
    6. Leveraged Loans: senior secured corporate loan to a high yield company
    7. Asset Backed Securities: a bond with loans or mortgages as underlying asset
  34. Fund: a fund is investment portfolio managed by an asset management company, which people can invest in.
    1. Closed-end fund: the number of shares in the fund is fixed. New investors have to buy the shares from existing investors.
    2. Open-end fund: the number of shares in the fund is flexible. When more people invest, new shares are created. When people sold the investment, the number of shares is reduced.
    3. Pooled fund: the source of money is from many people. Also known as mutual fund or collective investment scheme. Opposite: segregated mandate.
    4. Segregated mandate: the source of money is from one company. Opposite: pooled fund.
    5. Hedge fund: a fund that can invest in any asset classes, use a lot of leverage, and using long-short strategy. Opposite: mutual fund (can only invest in equity, cash and bond, not using much leverage, long only).
    6. Active Fund: the fund manager decides what shares/bonds to buy and sell, and when, in order to beat the benchmark.
    7. Passive Fund: the fund manager buys most of the shares/bonds that make up an index, in order to track that index. For a large index, they use sampling. Also called Index Fund or Tracker Fund.
    8. Smart Beta Fund: a fund which tracks an index that focuses on shares with low volatility, momentum, value, quality, size, share buybacks, or a combination of these factors. It is mainly equity funds at the moment.
    9. Multi Manager Fund: a fund which invests in other funds.
  35. Fund Sector: the grouping of funds based on their geography and characteristics. The most widely used grouping is from Investment Association. Most of IA Fund Sectors are obvious because they are regional, e.g. Asia Pacific. But some of Fund Sectors are not obvious, such as Equity Income, and they are listed here.
    1. Flexible Investment fund: the fund manager has flexibility over what to invest in e.g. equity, fixed income, cash, and currency. Also known as Multi Asset fund.
    2. Equity Income fund: at least 80% is in equity and intend to achieve a historic yield more than 10% above the MSCI World Index yield.
    3. Money Market fund: a fund which invests in money market instruments and deposits in credit institutions, and satisfies the FCA criteria in COLL 5.9.5.
    4. Personal Pension fund: a fund which only to be used for personal pension plan or Free Standing Additional Voluntary Contribution scheme (FSAVC).
    5. Property fund: at least 60% in property or at least 80% in property securities.
    6. Protected fund: a funds other than money market funds, which principally aim to provide a return of a set amount of capital back to the investor plus the potential for some investment return.
    7. Specialist fund: a fund with an investment universe which is not accommodated by the mainstream fund sector.
    8. Short Term Money Market fund: a fund which invests in money market instruments and deposits in credit institutions, and satisfies the FCA criteria in COLL 5.9.3.
    9. Sterling High Yield fund: at least 80% in GBP bonds (or hedged to GBP) which rating is below BBB minus, including unrated bonds but excluding convertible bonds, preference shares and PIBS
    10. Sterling Strategic Bond fund: at least 80% of the asset is in GBP denominated bonds (or hedged to GBP), excluding convertible bonds, preference shares, and PIBS.
    11. Targeted Absolute Return fund: a fund which aims to deliver a positive return in any market conditions.
    12. UK All Companies fund: at least 80% in the UK equities with the primary objective of achieving growth.
    13. UK Gilt fund: at least 95% in GBP government bonds (or hedged to GBP) with a rating higher or the same as UK, and at least 80% in UK government bonds.
    14. UK Index Linked Gilts fund: at least 95% in GBP government bonds (or hedged to GBP) with a rating higher or the same as UK, and at least 80% in UK Index Linked government bonds
    15. UK Smaller Companies fund: at least 80% in the bottom 10% UK companies by market capitalisation.
    16. Unclassified fund: a fund which does not want to be classified into other fund sectors, such as private funds.
  36. Fund Statistics:
    1. Alpha: an indicator of how much the fund outperforms a risk-free security. An alpha of 5 means that the fund outperforms a risk-free security by 5%.
    2. Beta: an indicator of how large the fund price changes relative to the benchmark price change. A beta of 1.5 means that if the benchmark falls by 3%, the fund will fall by 4.5%. A beta of 0.5 means that if the benchmark falls by 3%, the fund will fall by 1.5%.
    3. Excess Return: the performance return of the fund minus the performance return of the benchmark.
    4. Information Ratio: excess return divided by tracking error. The higher the Information Ratio of a fund, the more performance we get (compared to the benchmark), for the same amount of risk (with risk being the tracking error).
    5. Sharpe Ratio: (the performance return of the fund minus the performance return of a risk-free security) divided by the standard deviation of the fund. The higher the Sharpe Ratio of a fund, the more performance we get (compared to a risk-free security), for the same amount of risk (with risk being the volatility).
    6. R2: 1 minus (A/B), with A = sum of the square of (the fund daily return minus the benchmark daily return), and B = sum of the square of (the fund daily return minus the fund average return). It is an indicator of how close is the correlation between the fund and the benchmark. If the R2 is low, the benchmark is unsuitable.
    7. Tracking Error: the standard deviation of the difference between the fund performance return and the benchmark performance return.
    8. Volatility: the standard deviation of the fund performance return (not the fund’s price). Standard deviation is the square root of variance. Variance is the average of (the square of the difference between the daily fund performance return and the average return).
  37. Greeks: the sensitivity of the price (for derivatives)
    1. Delta: how much the price of an option changes when the price of the underlying equity changes by 1%
    2. Delta neutral trade: buying call and put options, so that when the underlying equity changes, the portfolio value does not change.
    3. Gamma: how much the delta of an option changes when the price of the underlying equity changes by 1%
    4. Vega: how much the price of an option changes when the volatility of the underlying equity changes by 1%
  38. Interest Rate Swap: an exchange of interest rate payments. We pay a fixed rate and receive a floating rate, to eliminate the risk of rate increase. Alternatively, we pay a floating rate and receive a fixed rate, to gain from a lower rate in the future.
  39. Instrument: a financial instrument or a security is a financial asset which can be traded. They are: equities, debt, cash, commodities, foreign exchange, and derivatives. A property such as land and building is an asset but it is not a financial instrument because it is not tradable.
    1. Equity instrument: a financial instrument which is a share of ownership in a company. In the US it is called Stock. In Europe it is called Shares.
    2. Debt instrument: a financial instrument issued a company or a government as a way to borrow money, with 1 year duration or more. They are: bonds, notes, certificates, mortgages, leases.
    3. Cash instrument: money held in a bank account in certain currency, or a money market instrument (such as certificate of deposit, repurchase agreement, commercial papers), or a very short term bond.
    4. Commodities: primary/base products such as metal, energy and agricultural products. Mining products: precious metal (gold, silver, platinum, palladium), base metals (copper, zinc, aluminium, nickel, tin), ferrous metal (iron ore, steel). Energy products: crude oil, natural gas, electricity, coal, refined products, biofuels, petrochemical. Agricultural products: corn, soybean oil, wheat, cattle, hog, milk, butter, cheese, timber, cocoa, sugar, palm oil. Other: diamond, rubber, wool.
    5. Derivative instrument: a financial instrument which value is determined from an underlying instrument.
  40. Instrument ID: a unique identifier of a tradable financial instrument/security.
    1. Bloomberg Ticker (BBG ID): a unique security identifier used in Bloomberg terminal covering shares, bonds, MBS, CMO, ABS, IRS, FRA, basis rates, volatility, indices, equity options, currencies, futures, option on futures, money market rates, energy.
    2. CINS (CUSIP International Numbering System): like CUSIP but for securities outside US and Canada.
    3. CUSIP (Committee on Uniform Security Identification Procedures): a unique security identifier in US and Canada, covering shares, bonds, index options, funds, CDs, MBS, CP, syndicated loans. CUSIP consists of 9 characters. The first 6 characters is the issuer ID. Options and futures don’t have CUSIP. It is maintained by Standard & Poor’s.
    4. ISIN (International Securities Identification Number): a worldwide unique identifier for a security. Not only shares but also bonds, options, futures, funds. ISIN does not specify in which Stock Exchange the security is listed. It does not identify the issuer.
    5. RIC (Reuter Instrument Code): a unique instrument identifier issued by Thomson Reuters covering shares, bonds, indices.
    6. SEDOL (Stock Exchange Daily Official List): a unique security identifier in the UK. It is 7 characters. It is maintained by London Stock Exchange.
    7. Ticker: a stock symbol used to identify shares traded in a particular stock market. It is either Bloomberg Ticker, Reuters RIC or TIDM/EPIC.
    8. TIDM (Tradable Instrument Display Mnemonic): the unique identifier of shares in London Stock Exchange. It is UK It was called EPIC (Exchange Price Information Code).
    9. VALOR Number: the security identifier in Swiss stock exchange.
    10. WKN (Wertpapierkennnummer): the security identifier in German stock exchange. Also known as WPK.
  41. Issuer ID: a unique identifier of the issuer of a bond or a share.
    1. CICI (CTFC Interim Compliant Identifier): identifier for all legal entities dealing in OTC derivatives in Commodity Futures Trading Commission (CFTC). To be replaced by LEI.
    2. CUSIP-6: the first 6 characters of CUSIP which identify the issuer. CINS-6: like CUSIP-6 but for CINS. See also: CUSIP, CINS.
    3. CMA Entity ID: the identifier of an organisation from Credit Market Analysis (now S&P Capital IQ).
    4. DUNS Number (Data Universal Numbering System): an identifier a company or a government, worldwide. It is not just issuers of bonds/shares, but all companies and governments in the world. It is maintained by Dun & Bradstreet.
    5. Fitch Issuer ID: unique identifier of a debt issuer, maintained by Fitch.
    6. GV Key: a global company identifier issued by Compustat. It is a 6 digit number. Covers public & private companies, ETFs, structured products,
    7. LEI (Legal Entity Identifier): global identifier for a legally distinct entity that engages in a financial Supported by FSB and G20. Provided by DTCC and Swift. It is called GMEI (Global Market Entity Identifier) by DTCC.
    8. Obligor ID: the unique identifier for a recovery obligor in Moody’s DRD (Default & Recovery Database) and URD (Ultimate Recovery Database). In CPMI, the Obligor ID contains LEI.
    9. Moody’s Issuer Number (MIN): unique identifier of debt issuer, maintained by Moody’s. It is a 10 digit number.
    10. Markit RED Code (Reference Entity Database): the identifier of reference entities trading in CDS market, maintained by Markit. It is a 6 characters. The reference obligations are 9 characters.
    11. S&P Ratings ID: unique identifier of a debt issuer, maintained by Fitch.
  42. Liquidity: how much volume a security is traded. If it is traded thousands times a day it is a liquid security. If it is only traded a few times a month it is an illiquid security. Another view: a liquid security is a security that we can sell within a few days, without causing a lot of decrease in price. An illiquid security is a security that we have to wait for weeks or months to sell it at normal price; or we can sell it this week at a large discount.
  43. Margin: the deposit in the futures market that buyers and sellers have to give to their brokers. The second meaning is borrowing money from the broker to trade.
  44. Mark to market: to get the fair market value of an OTC Derivative security, such as Interest Rate Swap.
  45. Market Trend: a long term characteristic of financial markets to move up or down.
    1. Bull market: a time period in the financial markets when the prices of financial instruments keep rising for a long period of time (more than 1 year) to more than twice the original prices. The scope of the market can be one country (e.g. China or India), several countries (e.g. emerging markets, or Asia), one asset class (e.g. bonds), several asset classes (e.g. equities and bonds), or the whole world. A bull drives its horns up into the air when attacking, hence the term.
    2. Bear market: a time period in the financial markets when the prices of financial instruments keep falling for a long period of time (more than 1 year). The scope of the market can varied as per the bull market above. A bear swipes its paw downward when attacking, hence the term. 20% decline in 2 months period is an indicator of a bear market.
    3. Market correction: a time period in the financial markets when the prices fall 5% to 20%, and then the prices go back up again, in less than a year.
    4. Dead cat bounce: a time period in the financial markets when the prices rise for 10% to 20%, and then the prices fall again, in less than a year.
  46. Maturity Date: the final payment date of a bond where the issuer pay the face value.
    1. Effective maturity date: the first call date of the bond.
    2. Maturity: the number of years from today until maturity date. Stated in fraction, for example: if the maturity date is 30/9/2022 and today is 19/10/2015, then the maturity is 2538 days / 365.25 = 6.9486653.
    3. Effective maturity: the number of years from today until the effective maturity date.
  47. Net Asset Value (NAV): (the total value of all positions in the fund minus the liabilities) divided by the number of outstanding shares. The positions include both securities and cash positions. The securities are valued at today’s close market price.
  48. Order Types (see also: Trade Types)
    1. Market Order: an order from a client to a broker to buy or sell a security at whatever price the market is at, when the order is executed.
    2. Limit Order: an order from a client to a broker to buy a security only when the market price is below a certain price. Or to sell a security only when the market price is above a certain price.
    3. Stop-Loss Order: an order from a client to a broker to sell a security that the client has, when the market price is below a certain price.
  49. Performance Return: how much the Net Asset Value changed between {a date in the past} and today. For 1 year performance return, the date in the past is a year ago. For 3 year performance return, the date in the past is 3 years ago.
    1. Gross Performance Return: before the fees are deducted.
    2. Net Performance Return: after the fees are deducted.
    3. Outperformance: the return of the fund minus the return of its benchmark.
  50. Price: for shares and commodities, price is determined from the last recent trade. For a bond, it is the present value of all future cash flow. For an option, the price is the premium. For a CDS, the price is the CDS spread.
    1. Ask Price: the lowest price that a seller is willing to receive. Also known as Offer Price.
    2. Bid Price: the highest price that a buyer is willing to pay.
    3. Mid Price: the average of (Ask Price and Bid Price).
    4. Opening Price: the price of the first trade on that day.
    5. Closing Price: the price of the last trade on that day.
    6. Dirty Price: the present value of all future cash flow, including Accrued Interest.
    7. Clean Price: the present value of all future cash flow, excluding Accrued Interest. The price on the Bloomberg terminal is Clean Price. Clean Price = Dirty Price minus Accrued Interest.
  51. Rating: capability of an issuer to fulfil its financial commitments. The correct term is “Credit Rating”. The top 3 credit rating agencies are S&P, Moody’s and Fitch.
    1. Investment Grade (IG): a bond with credit rating of AAA to BBB.
    2. High Yield (HY): a bond with credit rating of BB to D.
  52. Regulation about investment funds:
    1. AIFMD (Alternative Investment Fund Managers Directive): financial regulation applicable to hedge funds, alternative investment managers, private equity fund managers and real estate fund managers in the European Union.
    2. UCITS 5 (Undertakings for Collective Investment in Transferable Securities 5): a public company which manages investment funds in the European Union. UCITS allows funds to operate freely throughout the EU when one member country authorised it, and requires funds to appoint a depositary.
    3. MiFID 2 (Market in Financial Instruments Directive 2): provides financial product consumers with better clarity, higher ethical standards and more thorough reporting.
    4. EMIR (European Market Infrastructure Regulation): an EU regulation covering OTC, Central Counterparties and Trade Repositories to minimise counterparty credit risk.
    5. FATCA (Foreign Account Tax Compliance Act): US citizens must report their financial accounts and assets located in other countries, and financial institutions outside US must report the financial accounts and assets of US citizens to the US government.
    6. CRD 4 (Capital Requirement Directive 4): EU capital requirement regulation for credit institutions and investment companies implementing Basel III requirements.
    7. MAD 2 (Market Abuse Directive 2): regulation on insider dealing and market manipulation.
  53. Regulator: a government body in various countries that issue rules of how investment management companies should operate.
    1. Global Regulator: FSB (Financial Stability Board), IOSCO (International Organization of Securities Commission)
    2. US Regulator: SEC (Securities and Exchange Commission), FINRA (Financial Industry Regulatory Authority), CFTC (Commodity Futures Trading Commission)
    3. EU Regulator: European Commission, ESMA (European Securities and Markets Authority), EIOPA (European Insurance and Occupational Pensions Authority)
    4. UK Regulator: PRA (Prudential Regulation Authority), FCA (Financial Conduct Authority)
  54. Registrar: a company that keep a register of the holders of the unit trust shares or subscribers of the fund. See also: custodian, depositary.
  55. Repo (Repurchase Agreement): buying a bond then lend it back to the seller for a few days.
  56. Risk Free Security: a financial instrument which we are 100% certain that we will get the predicted return. For example: Treasury bills, cash in the bank, and money market instrument.
  57. Share Class: for a share, class A is offered during IPO to new investors, and class B is offered to existing shareholders with enhanced voting rights. Sometimes the reason is withholding tax on dividends. For a fund:
    1. Accumulation share class: the income (such as dividend and coupon) is invested back into the fund.
    2. Income share class: the income is paid to investors in cash.
    3. Net share class: the fund manager deducts the tax when paying the income to the investor.
    4. Gross share class: the fund manager does not deduct the tax when paying the income to the investor.
    5. Clean share class: after the Retail Distribution Review (RDR), the Annual Management Charge (AMC) that the investor pays includes the trail commission for the broker or platform. Also known as No Trail share class.
    6. USD/EUR/GBP share class: the fund is created with different base currencies.
  58. Sector: a way of classifying shares and bonds based on the industry sector of the issuer. Each of the providers below maintained a list of which company belong to which sector, worldwide (unless specified otherwise).
    1. Barclays Sector Classification: classifications of all issuers into 4 level 1s (treasury, government-related, corporate, securitized), 12 level 2s, 31 level 3s, and 72 level 4s.
    2. GICS (Global Industry Classification Standard): classification of all public companies into industry sectors maintained by MSCI and S&P. It consists of 10 sectors, 24 industry groups, 67 industries, and 156 sub industries.
    3. Markit iBoxx Corporate Sectors: classification of industry sectors maintained by Markit and used in their iBoxx indices. It consists of 2 top levels (financials & non-financials), 10 economic sectors, 19 market sectors, and 36 market sub-sectors.
    4. ICB (Industry Classification Benchmark): classification of 70k companies and 75k securities into industry sectors maintained by FTSE. It consists of 10 industries, 19 super sectors, 41 sectors, and 114 subsectors. It is used by NASDAQ and NYSE.
    5. ISIC (International Standard Industrial Classification of All Economic Activities): classification of economic activities created by United Nation. No mapping between companies and ISIC.
    6. Moody’s 35: a classification of all issuers into 35 industry categories.
    7. NAICS (North America Industry Classification System): a classification of industry sectors maintained by US and Canada governments. No mapping to companies.
    8. Sector Team: investment banks and asset managers split the team into sectors such as: Consumer & Retail, TMT (Technology, Media, Telecom), Industrial (Manufacturing, Infrastructure, Construction, Defence), FIG (Financial Institution Group), Natural Resources (Mining, Oil, Power, Utilities), Healthcare, Property.
    9. SIC Codes (Standard Industrial Classification): a classification of industry sector for each company in the UK registered with the Companies House. Maintained by ONS. Consists of 21 sections, 86 divisions, 272 groups, and 615 classes. SIC Codes are originally from US, replaced by NAICS, but SEC still uses SIC codes.
    10. TRBC (Thomson Reuters Business Classification): classification of industry sector maintained by Thomson Reuters consisting of 10 economic sectors, 25 business sectors.
  59. Seniority: the order in which a bond (or a loan) is paid, if the issuer / obligor went into liquidation.
    1. Senior Bond: A bond which is paid first when the issuer went into liquidation.
    2. Subordinated Bond: A bond which is paid after the senior bonds have been paid, if the issuer went into liquidation. Subordinated Bonds have 4 levels, from the lowest they are: Tier 1, Lower Tier 2, Upper Tier 2 and Tier 3. Subordinated Bonds are paid before the shareholders.
    3. First Lien Loan: a secured loan which, if the obligor went into liquidation, is paid before the second lien. It is paid by selling the collateral.
    4. Second Lien Loan: a secured loan which is paid after the first lien loans have been paid. It is paid by selling the collateral.
  60. Spread: there are 2 meanings of spread: 1) The difference between asking price and bid price, and 2) The difference the yield of an instrument and the reference rate (usually Libor for cash instruments and government bond for debt instruments). The second one is also known as Credit Spread or Yield Spread. See also: Spread Duration.
    1. Zero Volatility Spread (Z-Spread): a spread which, when added to the zero-coupon Treasury yield curve will make the price of the bond equal to the current market price.
  61. Stock Picking: a method of choosing which shares to buy
    1. Bottom Up: we evaluate each company individually and choose based on its predicted financial performance, regardless of its sector or country. See also: Sector.
    2. Top Down: we allocate the portfolio into different industry sectors and countries. The allocation percentages are based on the predicted performance of that sector and country.
  62. Trade: to buy or sell a security such as bonds, shares, or derivatives. Second meaning: to create a derivative contract with a counterparty. Third meaning: to invest or hold a position for a few hours.
    1. Trader: a person who buys or sells securities.
    2. Trade Life Cycle: order initiation, order execution, risk management, order routing, order matching, conversion into a trade, affirmation, confirmation, clearing, settlement.
    3. Trade Out: to cash-in a holding or a position.
    4. Trading Desks: a group of 3-10 people in a trading room doing analysis and trades, specialising in a particular asset class or sector such as IG Bonds, EM Bonds, shares, FX, and commodity.
    5. Trading Room: a room in an investment bank or asset manager full with Bloomberg Terminals, TradeWeb and Reuters Eikon where traders place their orders. Also known as Front Office, Dealing Room and Trading Floor.
  63. Trade Types (see also: Order Types)
    1. Spot Trade: buying or selling an asset with/for cash and the settlement is within 3 days.
    2. Future Trade: buying or selling an asset with the settlement date of 3 months or more.
    3. Swap Trade: a contract to exchange cash flow.
    4. Automated Trade: trades generated by computer system based on a predefined logic/rules, e.g. scalping, momentum, stop loss. Also known as Algo (algorithmic trading).
    5. Block Trade: a trade with very large quantity, executed privately “behind the scene” between two parties to get a good price. It’s not OTC as the trade will be booked later on the exchange.
    6. Cross Trade: a broker matching a buy order from one client and a sell order with the same quantity and price from another client, without booking the trade on the exchange.
  64. Trading Strategies: a method used to decide when to buy or sell
    1. Arbitrage: to gain from price differential by buying in a stock exchange with low price and sell it in a stock exchange with a higher price. Or buying a share or index when its corresponding future has a higher price (or lower price if shorting).
    2. Algorithmic: using mathematical model to decide buying and selling
    3. Fading: buying at the top for shorting
    4. High Frequency Trading (HFT): placing large numbers of orders in a short time in several stock exchanges simultaneously based on a preprogramed plan
    5. Index Fund Rebalancing: buying a new entry on the benchmark, on the day it appears on the benchmark, before the index funds buy that entry (share or bond).
    6. Mean Reversion: buying when the security deviates away from the mean and sell when it comes back to the mean.
    7. Momentum: buying when the security is on its way up, or shorting on its way down
    8. Pivot: buying at the bottom for long
    9. Volume Weighted Average Price: breaks a large order into small orders as small orders has more chance of getting better price.
    10. Scalping: selling as soon as it becomes profitable
    11. Swing: to hold for more than 1 day
    12. Time Weighted Average Price: breaks a large order into small orders executed at different hours during the day, when the price is close to the average price.
  65. Yield (for a bond): yield is the return divided by the investment value. In property business, yield is the rental income divided by the property value. In fixed income, it is coupon divided by the bond value (see Yield To Maturity, Yield To Call and Current Yield). In equity, it is the dividend divided by the equity value.
    1. Current Yield: the value of bond coupons for a year / purchase price x 100. Also known as Running Yield or Income Yield or Flat Yield. It is just the coupon without the price growth.
    2. Simple Yield: (the value of bond coupons for a year + 100 – purchase price) / purchase price x 100. It is coupon + price growth.
    3. Yield To Call: a callable bond means it can be re-bought by the issuer before maturity. Yield To Call is the value of all coupons until the call date, plus the principal amount received from the issuer at the call date, divided by today’s bond value.
    4. Yield To Maturity: the value of all coupons that will be received until maturity, plus the principal / face value, divided by the today’s bond value. Also known as Redemption Yield.
    5. Yield To Put: a putable bond means that we (the bond holder) can sell it back to the issuer, before maturity. Yield To Put is the value of all coupons until the put date, plus the principal amount received from the call date at the put date, divided by today’s bond value.
    6. Yield to Worst: the worst of (Yield To Maturity, Yield To Call and Yield To Put)
  66. Yield (for a fund): the total income generated by a fund for a year.
    1. Historic Yield: dividend in the last 12 months divided by today’s fund price. It is for an equity fund. The fund price is NAV (per share).
    2. Distribution Yield: (income expected in the next 12 months) divided by today’s fund price. It is for a bond fund, ETF and REIT.
    3. Underlying Yield: (income expected in the next 12 months + predicted capital growth – annual fund charges) divided by today’s fund price. It is for a bond fund, ETF and REIT.
  67. Yield Curve: a graph where the X axis is various maturity of a bond (3M, 6M, 1Y, 2Y, 5Y, 10Y, 15Y, 20Y, 30Y) and the Y axis is the Yield to Maturity (Redemption Yield) of the bond.
    1. Par Yield Curve: a Yield Curve when the bond is trading at par. Usually used in the primary market to determine the coupon.
    2. Spot Yield Curve: a Yield Curve but the Y axis is zero-coupon yields. Also known as Term Structure of Interest Rates.
    3. Yield Curve Surface: a 3D graph where the X axis is the year (e.g. 1990 to 2015), the Y axis is the Yield to Maturity of a bond, and Z axis is various maturity of the bond.

Source: Wikipedia, Investopedia, Trustnet, Pimco, FT Lexicon, IA, HL, Forbes, Nasdaq, SEC, FCA.

The ABC of Investing

US Equity

Just browsed the top 10 North American funds in FE Trustnet (by 1y, link) and they all jittery in the last 1y and have high volatility (risk between 110 and 140). True that they give good return (38%-42%), but their Sharpe is about 2-3. GAM NA Growth (FE, Morningstar) which I just sold is smoother than then top 10. Its risk is 93, 1y 29%.

Unicorn UK Smaller Co (link) is a better investment, with Sharpe of 5.9, risk of 71, 1y of 58.8%. It’s very smooth. Here’s a few other good ones from UK: Unicorn Free Spirit, Cazenove UK Smaller Co, IP UK Aggressive, Unicorn UK Income, ConBrio Sanford Deland UK Buffettology, CF Miton UK Multicap. Their return is about 40%, risk 50-110.

So I think I will be out of US market for the time being. US is still good in the long run, but it’s not as good as UK. Even Europe is generally better than US (in the sense that it gives better return for the same risk). US is good in the long run means that if we invest now, in 3 years time it will produce a good return. But it will be bumpy along the way. I will wait until it becomes smoother, probably March next year.

20th Nov 2013, note on US equity: Legg Mason Capital Management Opportunity had a stellar performance of 80% (71% in HL for A Acc). But the nasty 30% fall in July 2011 worries me. This indicates that when something goes wrong in the market, it would have a big fall. And the rebound was not quick. It got to Jan 2011 level in Jan 2013 (2 years period), whereas S&P fell 20% in July 2011 and got back to that level in Jan 2012 9only 6 months). There might have a change of policy or management in Nov 2012, because since then the performance was excellent: 70% in 1y versus S&P of 30%. The market fall in June 2013 and mid Sep was handled very well by this Legg Mason fund. Overall it is a good fund and worth considering. Whitechurch uses it.

The fund may invests in equity, bonds, derivatives, and not limited by industry, size or asset class. It’s in USD.

US Equity

Focus on UK

UK equity is the best investment in the next 1 year, and for 2 year horizon it’s US and Europe. Japan is oscillating converging so I am avoiding it at the moment. Bond has been poor since May so we should avoid it, including bond in mixed investment and IL gilts. Strategic bond is better, but I would avoid as there are better places (for now). China had a sharp drop in June, but has been better ever since. Still, I would avoid China because there are better places. It is possible that strategic bond and china are investable in 2014, but at the moment they are not. EM is also not investable in 2013. Absolute Return looks like bond: less risky. Avoid gold and commodity, they are not investable (loss making and risky).

I prefer a portfolio of something like: 40% UK Equity, 10% US Equity, 10% Europe Equity, 10% Absolute Return, 10% Healthcare, 20% Asia Property. Or make UK Equity 50%, reducing both Absolute Return and Healthcare to 5%. For UK, US and Europe equities, I prefer small cap. But I’m open to equity income and absolute return if they are brilliant, for example IM Argonaut European Absolute Return (33%, 10), Cazenove European Income (34%, 16) and Cazenove UK Opportunities* (39%, 10). Numbers in brackets are 1y return and vol. Star indicates that I have it in my portfolio.

Best small cap for UK are Cazenove* (45%, 7) and Fidelity* (52%, 8), who have been in the top spot for a long time. For Europe, best small cap are Ignis* (50%, 14) and Schroder (45%, 13). For US, Threadneedle (32%, 16) and GAM* (27%). For Absolute Return the best one is Cazenove Absolute UK Dynamic* (19%, 9). For Healthcare my preference is Schroder* (32%). One factor that limit me from getting the best fund in FE is if the fund is not available in my brokers (HL & TD), or if there is a big spread. For example, in Absolute Return CF Odey is legendary, but it it’s not available.

If those good funds are currently down, it is important that we wait until it has bottomed and goes back up. We should never catch a falling knife. But leave it drops to the floor and pick it up on the way up. Classic I know, but very important. With funds, which lag 1-2 days to equity, it becomes more important that we wait until it has bottomed. The other thing I keep reminding myself is that if the price has rocketed to the sky, such as Argonaut European Absolute Return, the risk of it dropping is big. Especially if it is long only. With Absolute Return it is possible to sustain the phenomenal growth because it is long short hedged.

One word about Asia property. Hong Kong, Dubai, India and Indonesia (Jakarta, Bali) have been enjoying good growth for years. In Jakarta & Bali, return of 25% is a normal case, 40% happens quite often. Dubai is behind, about 15-20%. One drawback we have to be careful is FX. Since August, India and Indonesia had FX issues. We are talking about 20% down here. Rupiah which has been 15k for years is now 18k. Which means that a return which should be 10k became only 8k. Shanghai and HK are question mark, so is Manila (we are talking 10% there). Nairobi and Thailand’s time has passed. India has just burst. My preference is Jakarta.

The focus of investment today should be UK. 40-50% allocation. In the next 6 months small cap will still give better return than large cap, and equity income. March 2014, we need to look at large cap. We should not balance it, but should tip heavily towards the high growth area. And for the next 3-6 months that area is UK.

Focus on UK

Equity Income and Absolute Return Funds

With the bond funds now seem having low returns in the next 2 years, Equity Income Funds and Absolute Return Funds are better choices.

In the last 1 year, GBP Corporate Bond Funds returned 3.6% (top 10 4.2%) whereas UK Equity Income 24.9% (sources are in the links, from Trustnet), and the average of top 10 is 35.0%. Absolute Return Funds returned 5.6%, but the average of the top 10 is 18.2%.

After up 6% from Feb to May, GBP Corporate Bond sector was down 6% in May. In July it was up 2% then down 2% again in August. From Sep it is up 3%. Hence 3.6% in the last 1 year. I can’t invest in a yoyo sector like this. And the prospect is not looking good either, because of interest rate raise. I pulled out from Corporate Bond in Feb, and switched to equity. In the last 6 months, every fund in the top 10 return negative.

UK equity income looks good so far, and the future looks bright too. From October 2012 to May it was up 20%, down 10% in June, up 10% in July, flat in Aug & Sep, then up 5% in Oct. Hence 24.9% return in the last 1 year. My choice in this sector in Unicorn UK Income, which returned 41.1% in 1 year with volatility of 8.1%. That is better than Invesco Perpetual High Income, which returned 21.9% with 9.2% volatility.

The Absolute Return sector looks good too. It was up 5% since October 2012 until May, then down 2% in May-June, up 2% in July, flat in Aug-Sep and 1% in October. My choice is Cazenove UK Absolute Dynamic, which returned 16.3% in the last 1 year, with 4.5% volatility! This fund is consistently upwards since Oct 2012.

Date written 25/10/2013

Equity Income and Absolute Return Funds


The second most important parameter to look at when considering an investment is the volatility (the most important one is the Return, see here). Volatility is important because it shows how varied the price is. In other words, how consistent the growth is.

Why the consistency of the growth is important? Take a look at this chart:

Low and High Volatility

All 4 lines starts from 100 and ends on 119. But how they arrive at 119 are very different. The volatility of these 4 lines are green: 8.93, red: 9.65, blue: 1.54, purple: 5.34.

Red is up and down like a yoyo. In Sep 2012 I would have no clue whatsoever whether in the next few months it would be going up or down. It goes from +15 and +17 in Oct 2011 and Apr 2012 to -13 in March 2012. Statistically, because it’s like up & down dramatically like a yoyo, the probability of it’s going up is almost the same as it’s going down. The future is completely unpredictable.

Green is shooting up very high in Oct to Dec 2011, then flat in Jan and Feb and down a lot in March. Then up very high again in April, then stepping down until Sep 2011. It goes from +13.5, +12.5 and +17 in Oct 2011, Dec 2011, Apr 2012 to -13 in Mar 2012. Again, we have no idea of where it’s going. But judging by “the near past is more influential than distant past”, in a few months from Oct 2012 I think the probability of it’s going down is high than going up.

Blue is pretty consistent with the growth. It goes from +4 in Jan 2012 to -1.5 in Mar 2012. It is almost a straight line. It is by far more resembling a straight line than red or green. From May to Sep it has been pretty consistent with growing +1 to +2 each month. It is much more predictable than Red or Green. In a few months from Oct 2012 I am pretty sure it will continue to go up at the same pace.

Purple was pretty much flat for 9 months from Nov 2011 to Aug 2012 then suddenly shoot up to reach 119. It is far better than Red or Green, but it is worse than Blue. It is better than Red or Green because staying flat is better than going up and down like a yoyo. But going up consistently +1.5 each month like Blue is better than staying flat for 9 months then shoot up at the end. Better means more predictable.

Yes you are right, I am assuming that if it has been rain, rain, rain in the past 6 days, then the chances of it going rain tomorrow is bigger than sunshine. And if it has been sunshine for the last 6 days, the changes of it’s going to be sunshine on tomorrow is bigger than raining.

If the growth has always been +2 in the past 6 months, the chances of the growth being +2 next month is a lot higher than if it has been yoyo-ing +2, -2, +2, -2, +2, -2.

These charts represents either a company, or a fund (or commodity, or FX). There are real things behind these charts. Assume we are talking equity. These 4 lines are 4 different companies in the stock market. Company red which is up and down like yoyo, is not trustable at all. There is something fundamentally wrong with this company. Why is the share price goes up and down like yoyo? Why did people rushing to buy (hence the price was up) then the following month people rushing to sell? Why in Feb people were buying, in March people were selling, in April buying, in May selling, in June buying, in July selling? We need to find out what’s going on inside this company. There must be something going on. There is no smoke without fire.

Company blue on the other hand is much more consistently growing compared to Red. It is a much more stable company. And because the company is more stable (based on the share price), it is more predictable.

If I have to choose between these 4 companies to buy, hands down I will choose Blue. It is buy far the most stable, the most predictable growth. Yes all for of them gives the same return (from 100 to 119 in a year = 19% return), but I have to predict the future movement, I say that Blue has the highest change of making good, consistent growth in the future.

There is another reason why I prefer the one most resembling straight line (Blue) than the yoyo ones like Red. If it is straight line, I can exit at any time without problem. If it is yoyo-ing, exiting could be a little problem. For example, March 2012 was a bad time to exit from Red because the price was down 12.

If a company made a big fall in the past it is more likely to make it again in the future. Red and Blue in March are both down 12. Whereas Blue is never down more than 1.5. Compare 12 and 1.5: the 12 are more scary! We know that if we buy Blue, if it goes down, it doesn’t go down much. Whereas if we buy Red or Green, we must be prepared to accept big falls.

The volatility of these 4 lines are green: 8.93, red: 9.65, blue: 1.54, purple: 5.34. Blue has the lowest volatility (“vol” for short). Low vol means “growth is consistent”, like it’s always +1 or +2 every month. Red and Green have the highest volatility. High vol means “up and down violently like a yoyo”, like Jan +10, Feb -13, March +15, … Purple’s vol is in the middle between Red/Green and Blue. It’s not “growing consistently” and it’s not “up and down like yoyo” either. It’s consistently flat then up.

So we prefer investment with low vol. Meaning that its growth is consistent.

Calculating Volatility

Calculating Volatility - Blue

These are the numbers for Blue. The growth is between +4 (Jan) and -1.5 (Mar). The average of growth is 1.58.

Delta means how far is the growth from the average. In Oct 2011, the growth is 3.5, so the Delta is 3.5-1.58 = 1.92. In Nov 2011, the delta is 1.5-1.58 = -0.08. Delta^2 means Delta Squared = Delta2. In Oct 2011 the Delta2 was 1.922 = 3.67. And in Nov 2011 the Delta2 was (-0.08)2 = 0.0069, rounded to 0.01. The reason we square the Delta is to avoid the negatives cancelling the positives.

If we average all the Delta2, we get 2.37. This is called the Variance. Variance is a measure of how far a set of numbers are spread out from the mean.

If we take the square root of the variance, we get Standard Deviation (SD). Its matematical symbol is Greek alphabet sigma: σ. It also shows how spread out the values are from the mean. In investment, the values we are comparing is the growth. Hence it is called volatility, meaning how volatile the price is, how different the growth is from one day to the next.

In the growth is distributed normally, 1 sigma = 68%, 2 sigma = 95%, 3 sigma = 99.7%. In the above case of Blue, the sigma is 1.54. Hence 2 sigma = 3.08 so 1.58 ± 3.08 covers 95% of the population.

Below are the calculations for Red, Green and Purple:


Calculating Volatility - Red


Calculating Volatility - Green


Calculating Volatility - Purple



Return is how much money the investment has grown. In other words, it is the value of it today, compared to its value in the past.

As always it is better to use an example when explaining. Consider the following investment, Red and Blue:


During the 3 years period (Sep 2009 to Sep 2012), Red grew from £100 to £142, whereas Blue grew from £100 to £184. So Red made £42 and Blue made £84. Red’s return is 42% for 3 years, or 14% per year. Blue’s return is 84% for 3 years, or 28% per year. This 14% and 28% are not accurate, because the return is compounded. The accurate numbers are 12.4% (cube root of 1.42 minus 1) and 22.5% (cube root of 1.84 minus 1).

Return is the most important parameter when considering an investment (the other being the risk). We simply pick the one with the highest return. This sounds very simple, but many people don’t always see it clearly.

That is why it is called “Return on Investment”. It is how much money the investment is making. We have an investment £100 in Red and we get £42. We invest £100 in Blue and get £84.

Let do another example so we really understand the formula. This time the prices don’t start at 100:

Not from 100

Red starts from 140 and grew to 182. Blue starts from 120 and grew to 204. The gain is 42 for Red and 84 for Blue, for 3 years. The return for Red is 42/140 = 30%, and for Blue 84/120 = 70%. These 30% and 70% are for 3 years, so per year the return is 10% for Red and 23.3% for Blue. This 10% and 23.3% are not accurate, because the return is compounded, so it is not linear. The accurate numbers are 9.14% (cube root of 1.3 minus 1) and 19.3% (cube root of 1.7 minus 1).

What if it doesn’t cover 3 years duration? Like this:

Diff duration

Red covers 3 years (Sep 2009 to Sep 2012) but Blue is only from March 2010 (30 months = 2.5 years).

Return for Red = (180-140)/140 = 40/140 = 28.6% for 3 years. So per year the return is cube root of 1.286 minus 1 = 8.75%.

Return for Blue = (180-120)/120 = 60/120 = 50% for 2.5 years. So per year the return is the 2.5th root of 1.5 minus 1 = 1.5 ^ (1/2.5) – 1 = 17.6%.

So that is how we calculate the return on an investment. This is the number one consideration when investing (in my opinion) so we need to understand it well.

I believe we should learn from actual numbers, not theoretical cases. This is Apple shares, from 18 Sep 2009 to 21 Sep 2012: (source: Google Finance)


Apple share price grew from $185 on 18/9/2009 to $700 on 21/9/2012.
Return = ($700-$185)/$185 = $515/$185 = 278.38% for 3 years = 55.83% per year.

On 23 Sep 2011 the share price was $404.
Return = ($700-$404)/$404 = $296/$404 = 73.3% for 3 years = 20.1% per year.

So the return based on 3 years data is not the same as the return based on 1 year data.

Is 20.1% a good return or not? Yes it is a good return. Generally speaking, for the period Sep 2011 to Sep 2012, return above 10% is a good. Above 20% is very good. How do I know this? By looking at major indexes. An index like FTSE 100 or S&P100.

This is S&P 500 Jun 2011 to Sep 2012:


On 21 Sep 2009, S&P 500 was 1460. On 25 Sep 2009, S&P 500 was 1044. The 3Y return therefore is (1460-1044)/1044/3 = 13.3%

On 23 Sep 2011, S&P 500 was 1136. The 1Y return is therefore (1460-1136)/1460/3 = 9.5%


FTSE 100 (above) was 5853 on 21/9/12, 5067 on 23/9/11 and 5082 on 25/9/09. In case you are wondering why not all 3 years on 23 Sep, it’s because Google Finance data is on Fridays (weekly data). So the 1Y return is 5.2% and 3Y return is 5.1%.

S&P500 is reflects the growth of the biggest 500 companies in the US. FTSE100 reflects the growth of the biggest 100 companies in the UK. Which is why Apple’s 20.1% return is good. Because it’s higher than the FTSE’s 5% and S&P’s 9%-13%.