ABC of mutual fund investing

Volatility

Modern Portfolio Theory is an investment approach that explores how investors can design portfolios to seek the best potential return for an assumed level of portfolio risk. The theory also quantifies the benefits of asset allocation, which is the practice of seeking to reduce investment risk by strategically dividing assets among several different asset classes. The asset allocation process starts by considering time horizon, return objectives and risk tolerance. Though asset allocation cannot eliminate investment risk or losses, it may provide opportunities to lessen a portfolio's volatility.

Using a number of statistical measures, an investor can use modern portfolio theory to classify or estimate the amount of assumed risk and potential reward in a portfolio. The statistics provided in the Mutual Fund Center are based on the fund's performance over the time periods noted.

Alpha
Measures the difference between a fund's actual returns and its expected performance, given its level of risk (as measured by Beta). Alpha combines the volatility the fund's price has experienced relative to the market and the returns the fund has generated relative to the market, to define the "excessive risk" of the fund. A negative Alpha means a fund has underperformed its index relative to how much volatility has been shown.

Beta
Measures the fund's sensitivity to market movements. A portfolio with a Beta greater than 1.00 is more volatile than the market, and a portfolio with a Beta less than 1.00 is less volatile than the market. Therefore, the higher the Beta, the more sharply the fund's price has moved in relation to the market's movement.

Standard Deviation
A statistical measure of the volatility of the fund's returns. The higher the fund's standard deviation, the greater its volatility has been.

Sharpe Ratio
A measure that uses the standard deviation and excess return to determine reward per unit of risk. The Sharpe Ratio is a measurement of risk-adjusted performance calculated by dividing the excess return of a portfolio above the risk-free rate by its standard deviation. High values indicate greater return per unit of risk.

R-squared
A measure that reflects the percentage of a fund's movements that are explained by movements in its benchmark index, showing the degree of correlation between the fund and the benchmark. R-squared measures how closely correlated the fund's performance was to the index. The higher the R-squared statistic (out of a possible 100), the more relevant the Alpha and Beta figures may be.
(courtsey, Wellsfargo bank)