1. TERMS AND TECHNOLOGY

2. WHAT YOU WILL LEARN Terms Terms Risk Risk Rebalancing Rebalancing Technology Technology Hypothetical Illustrator Hypothetical Illustrator Portfolio Solutions Portfolio Solutions

3. TERMS – RISK & RETURN Risk Risk Alpha Alpha Beta Beta R 2 R 2 Standard Deviation Standard Deviation Sharpe Ratio Sharpe Ratio

4. TERMS Beta Beta This tells us how much risk a portfolio is taking compared to its benchmark This tells us how much risk a portfolio is taking compared to its benchmark The benchmark is always assigned a number of 1.00 The benchmark is always assigned a number of 1.00 Example Example The benchmark is the S&P 500 The benchmark is the S&P 500 Since the S&P 500 is the benchmark, it is automatically assigned a beta of 1.00 Since the S&P 500 is the benchmark, it is automatically assigned a beta of 1.00 If a portfolio is said to have a beta of 0.90, that means the portfolio is taking 10% less risk than the benchmark If a portfolio is said to have a beta of 0.90, that means the portfolio is taking 10% less risk than the benchmark If a portfolio is said to have a beta of 1.10, that means the portfolio is taking 10% more risk than the benchmark If a portfolio is said to have a beta of 1.10, that means the portfolio is taking 10% more risk than the benchmark Beta can also be used as an indicator of performance Beta can also be used as an indicator of performance

5. R 2 R 2 What’s wrong with this statement? What’s wrong with this statement? “My portfolio has a beta of 0.90 so it is less risky.” “My portfolio has a beta of 0.90 so it is less risky.” Less risky than what? Less risky than what? Is that a relevant benchmark to compare it to? Is that a relevant benchmark to compare it to? Which makes more sense? Which makes more sense? “My portfolio is less risky than betting all of my money on one hand of blackjack.” “My portfolio is less risky than betting all of my money on one hand of blackjack.” “My portfolio is less risky than peeing on an electric fence.” “My portfolio is less risky than peeing on an electric fence.” TERMS

6. R 2 (continued) R 2 (continued) R 2 helps you determine if you are comparing your portfolio to something relevant R 2 helps you determine if you are comparing your portfolio to something relevant You can’t talk about the alpha or beta without knowing what R 2 is You can’t talk about the alpha or beta without knowing what R 2 is According to Morningstar, you should have a R 2 of 75 or higher According to Morningstar, you should have a R 2 of 75 or higher If the R 2 is less than 75, then alpha and beta numbers are meaningless If the R 2 is less than 75, then alpha and beta numbers are meaningless TERMS

7. Alpha Alpha Alpha gauges risk and return together Alpha gauges risk and return together Alpha measures the difference between a portfolio's actual returns and its expected performance Alpha measures the difference between a portfolio's actual returns and its expected performance Alpha is often seen as a measurement of the value added or subtracted by a portfolio's manager Alpha is often seen as a measurement of the value added or subtracted by a portfolio's manager If a fund returns more than what you'd expect given its beta, it has a positive alpha If a fund returns more than what you'd expect given its beta, it has a positive alpha If a fund returns less than its beta predicts, it has a negative alpha If a fund returns less than its beta predicts, it has a negative alpha TERMS

8. Standard Deviation Standard Deviation Standard deviation measures how much a fund fluctuates compared its average Standard deviation measures how much a fund fluctuates compared its average Example Example A mutual fund that gained 1% each and every month over the past 36 months would have a standard deviation of zero, because its monthly returns didn't change from one month to the next A mutual fund that gained 1% each and every month over the past 36 months would have a standard deviation of zero, because its monthly returns didn't change from one month to the next A mutual fund that lost 1% each and every month would also have a standard deviation of zero A mutual fund that lost 1% each and every month would also have a standard deviation of zero Why? Because, again, its returns didn't vary Why? Because, again, its returns didn't vary A fund that gained 5% one month, 25% the next, and that lost 7% the next would have a much higher standard deviation because its returns have been more varied. A fund that gained 5% one month, 25% the next, and that lost 7% the next would have a much higher standard deviation because its returns have been more varied. TERMS

9. Standard Deviation (continued) Standard Deviation (continued) Standard deviation allows a fund's performance swings to be captured into a single number Standard deviation allows a fund's performance swings to be captured into a single number For most funds, future monthly returns will fall within one standard deviation of its average return 68% of the time and within two standard deviations 95% of the time For most funds, future monthly returns will fall within one standard deviation of its average return 68% of the time and within two standard deviations 95% of the time Translation Translation Say a fund has a standard deviation of 4 and an average return of 10% per year Say a fund has a standard deviation of 4 and an average return of 10% per year Most of the time (or, more precisely, 68% of the time), we can expect the fund's future returns to range between 6% and 14% or its 10% average plus or minus its standard deviation of four. Most of the time (or, more precisely, 68% of the time), we can expect the fund's future returns to range between 6% and 14% or its 10% average plus or minus its standard deviation of four. Almost all of the time (95% of the time), its returns will fall between 2% and 18%, or within two standard deviations of its average Almost all of the time (95% of the time), its returns will fall between 2% and 18%, or within two standard deviations of its average TERMS

10. Average Return: 10% Standard Deviation: 4 6%14% 10% 18% 2% 1 Standard Deviation (68% of the time) 2 Standard Deviations (95% of the time) 1 Standard Deviation (68% of the time) 2 Standard Deviations (95% of the time) TERMS

11. Sharpe Ratio Sharpe Ratio The Sharpe ratio uses standard deviation to measure a fund's risk-adjusted returns The Sharpe ratio uses standard deviation to measure a fund's risk-adjusted returns The higher a fund's Sharpe ratio, the better a fund's returns have been relative to the risk it has taken The higher a fund's Sharpe ratio, the better a fund's returns have been relative to the risk it has taken Because it uses standard deviation, the Sharpe ratio can be used to compare risk-adjusted returns across all fund categories (alpha and beta can only be used to compare funds in the same fund category) Because it uses standard deviation, the Sharpe ratio can be used to compare risk-adjusted returns across all fund categories (alpha and beta can only be used to compare funds in the same fund category) TERMS

12. Rebalancing Rebalancing Rebalancing helps put our portfolio back to its intended allocation Rebalancing helps put our portfolio back to its intended allocation Example: Example: Initial portfolio design Initial portfolio design Fund A: 50% Fund A: 50% Fund B: 50% Fund B: 50% After 1 year After 1 year Fund A: 60% Fund A: 60% Fund B: 40% Fund B: 40% Rebalancing puts them both back to 50% Rebalancing puts them both back to 50% TERMS

13. Morningstar Tools Morningstar Tools Hypothetical Illustrator Hypothetical Illustrator Used to prove concepts or show past performance of a portfolio Used to prove concepts or show past performance of a portfolio Portfolio Solutions Portfolio Solutions Used to compare past performance of two portfolios Used to compare past performance of two portfolios TECHNOLIOGY