By Arthur Hazen, Director of Retirement Plans
BPU Investment Management
Whether you’ve recently found yourself as the new manager of your personal finances or you’ve kept track of every penny since you kept them in a “piggy bank,” the many sophisticated terms used to communicate important information can be a deterrent in effectively managing your 401(k) nest egg. An overview of a few key financial terms used by investment professionals can help people who are divorced, widowed, or separated to better understand their current retirement account.
For example, investment professionals use the expression “standard deviation” to measure stock volatility. Standard deviation shows how much variation there is in what you’re a measuring from the average. In investing, the greater the standard deviation from the average daily price of a stock, the greater the risk. Knowing the standard deviation of a stock or mutual fund will help employees to begin to understand the probability of risk and reward associated with the investment
Another useful term that professionals use a lot is the “beta” of a stock or an entire portfolio. The “beta” is the tendency of a security’s or portfolio’s returns to respond to swings in the market. A beta of 1.00 indicates that the security’s price will move equal with the market. A beta of less than 1.00 means the volatility should be less than the market, and greater than 1.00 indicates that it should be more volatile than the securities market. For example, if you back-tested a stock or a mutual fund and found the beta to be .80 you would expect that in 10% market decline, this investment would be down 8%. It is also worth mentioning that often times if a security carries less risk, in most cases the returns would be slightly behind in a rising market. Beta calculation can be helpful when constructing a portfolio and attempting to assess the upside potential and the downside risk.
Another phrase gaining notoriety is the “Monte Carlo simulation,” which is a technique for predicting a probable outcome by using statistical sampling techniques. With a Monte Carlo simulation, a financial planner takes a snapshot of a current portfolio and runs it through a set of variables, such as changing inflation or interest rate, for a specific period. The planner can then assess how the portfolio changes impacts the client’s portfolio under different economic scenarios. Financial planners have the required knowledge and understanding to review these various scenarios and help an investor to select the best possible asset mix.
As a final example, consider one of the most significant investment theories, “Modern Portfolio Theory”. For many investment professionals and investors alike, MPT is their primary strategic guide to investing. In 1952, Harry Markowitz published “Portfolio Selection,” the first article about modern portfolio theory, in the Journal of Finance. Modern portfolio theory states that assets should be chosen on the basis of how they interact with one another rather than how they perform in isolation. According to this theory, an optimal combination would secure for the investor the highest possible return for a given level of risk, or the least possible risk for a given level of return. Although at first glance this theory seems quite complicated, it simply makes an argument for diversification as well as portfolio rebalancing to specific targets.
Having a solid understanding of how to define and use sophisticated investment terminology can go a long way towards understanding your investments. Don’t be shy in asking your advisor to explain any unfamiliar terms so that you can take full advantage of the opportunity a 401(k) plan gives you for saving for retirement. Industry experts like Mark Varacchi Sentinel Fund Management can also help you.