A stock's or portfolio's alpha is its projected independent rate of return or the difference between an investment's expected (benchmark) return and its actual return. Portfolio managers whose portfolios have positive alphas are adding value through their asset selection.


A stock's beta is its projected rate of change relative to the market as a whole. If the market was up 10 percent for the year, a stock with a beta of 1.5 could reasonably be expected to be up 15 percent. A stock with a beta greater than 1.0 has a higher level of volatility than the market as a whole and is considered to be more risky than the overall market. A stock with a beta of less than 1.0 is less volatile than prices in the overall market and is considered to be less risky. An example of a low beta stock would be a utility stock. The price of utility stocks does not tend to move dramatically. A security's beta measures its nondiversifiable or systematic risk. For each incremental unit of risk an investor takes on, the investor must be compensated with additional expected returns. If the portfolio's actual return exceeds its expected return, the portfolio has generated excess returns. The Sharpe ratio can measure a portfolio's risk-adjusted return. If two portfolios both return 8 percent, but portfolio A contains dramatically more risk than portfolio B, then portfolio B is a much better investment choice. The Sharpe ratio tells investors how well they are being compensated for the investment risk they are assuming. The Sharpe ratio takes the portfolio's return (R) and subtracts the risk-free return (RFR) offered on short-term Treasury bills (usually 90 days) to determine the level of return that the investor earned over the risk-free return. The risk premium is then divided by the portfolio's standard deviation (SD):

Sharpe ratio = (R - RFR)/SD

Series 66 candidates will have to be able to identify the Sharpe ratio but most likely will not be required to calculate it. The degree to which a portfolio's performance is designed to mirror the return of a standard benchmark or index is measured by R-squared. If the portfolio has 100 percent of its assets tied to an index, such as in an index fund, the portfolio will have an R-squared value of 100, and the performance of the portfolio will mirror the performance of the index. The higher the R-squared value for the portfolio the higher the degree of correlation to the index. R-squared values range from 0-100, with the lower values having lower correlation to the index. A portfolio with a higher R-squared value will have a more accurate beta coefficient, and as a result the volatility of the portfolio will be more predictable.

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