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140 * Daniel Kahneman & Amos Tversky, " Subjective Probability: A Judgment of Representativeness," Cognitive Psychology 3 (1972): pp. 43054. Random WalkA process in which each event or measurement is uncorrelated with, and cannot be predicted from, any past events or measurements of the same process. Real ReturnA retum that has been adjusted for inflation. Recency and SaliencyTwo aspects of eventshow recent they are and how much of an emotional impact they have (often establishing a case rate) that contribute to their being given greater weight tiian prior probabilities (i.e., the base rate). See also availability, heuristics, representativeness. Regression to the MeanThe tendency of extreme events to discontinue, and for processes to revert to their mean values. For example, a study of the height of men found that the tallest men usually had shorter sons, while the shortest men usually had taller sons. Reinforcing EventAn event that reinforces perceptions, such as a positive eamings surprise on a favored stock, or a negative surprise on an unfavored stock. In contrast to event triggers, reinforcing events generally have littie or no impact on stock price. RepresentativenessA subjective judgment of the extent to which the event in question "is similar in essential properties to its parent population" or "reflects the salient features of the process by which it is generated."* Return on EquityAftertax profit divided by net worth. Return on SalesSame as profit margin. Risk AversionThe academic expectation that investors will demand greater return in exchange for taking on greater risk, usually defined as volatility. Russell 2000 IndexThe most widely followed small cap index. S&P 500 IndexA valueweighted index of 500 large cap stocks specifically selected to represent all major industry groups. It is the most commonly used market index in statistical studies. SharpeTVeynor IndexA measurement of return that takes into account the amount of volatility in a stock or portfolio; essentially a "riskadjusted" return. Small CapShort for small capitalization. Smallcap stocks are generally considered to have market capitalizations roughly between $100 million and $1 to $2 billion (altiiough stocks in die $500 million to $1 to $2 billion range are often called "midcaps"). Stocks smaller than about $100 million are often called "microcaps." Standard DeviationA statistical measure of the amount of spread, or scatter, of a collection of measurements about the average. Standard deviation answers the question, are the measurements packed closely together, or spread far apart? Standard deviation of retums is widely used as a risk measurement. Generally, the larger the standard deviation the greater the
uncertainty (or risic) in the measurement. About twothirds of the measurements nonnally lie within one standard deviation of the mean. Statistical SignificanceThe probability diat a statistical measurement has a causal relationship between the factors measured rather than simply being random chance. In economics, and many odier social sciences, a 5% level of significance (5% chance diat the measurement was random) is considered the standard threshold for accepting or rejecting a hypothesis. Survivorship BiasThe failure to use all stoclcs in studies of past returns that would have been available to investors at that time. Stocks that did poorly and disappeared due to bankruptcies and reorganizations are sometimes not picked up in databases. Systematic RiskRisk diat is endemic to the market, i.e., that cannot be reduced through diversification. Also called market risk. TtestA common test that uses mean and standard deviation to measure statistical significance levels. Tactical Asset Allocation (TAA)The attempt to move into and out of various markets at the right time. TAA shifts the portfolio mix (normally stocks, bonds, and cash) as conditions change. Most TAA signals are based on both economic and market indicators. Technical AnalysisThe practice of studying past pattems in price movements to determine future price movements (compare fundamental analysis). TechnicianOne who believes in and practices technical analysis. Thin MarketA market exhibiting low liquidity. Transaction CostsThe costs of trading due to brekers commissions and bid/ask spreads, as well as any additional fees (usually very small) imposed by the exchange or by regulatory agencies. Treasury Bills (TBills)Notes issued by the U.S. Govemment usually weekly and usually payable after 90 days (and in some cases up to 12 months). Tbills do not pay interest. Rather, they are sold at auction and the buying price is discounted by the market to the face value of the bill to reflect an equivalent interest rate. See also zerocoupon bonds. Treasury BondsBonds issued by the U.S. Government that pay regular interest (with the exception of zerocoupon bonds). U.S. Treasury bonds are a standard benchmark for bond retum. TtimoverThe rate at which a portfolio changes its stock or bond holdings, usually stated as a percentage of assets each year. TwoTier MarketA market, such as the stock market of die early 1970s, in which a select segment of favored stocks were priced much higher (i.e., had much higher P/E ratios) than other stocks in the market. Value StockA low P/E, low pricetobook or odier stock, that is believed to be good value for the money. ValueWeighted RetumThe retum on a portfolio in which each stock begins with an amount of money invested in it that is proportional to its market value. Also called a marketweighted retum. See also market capitalization, equally weighted retum.
VarianceA statistical measure of the amount of variation in a series of returns, very similar to the standard deviation. Academics often use variance in combination with the mean to describe the theoretical relationship between risk (as measured by variance) and return (as measured by the mean). VisibilityClearly definable prospects, such as projected eamings growth, for a company or an industry. VolatilityA measure of the amount a stock or portfolio moves up and down relative to some average. Usually measured by standard deviation, covariance, beta, etc. Wealth RelativeAcademic jargon for the value of a portfolio per dollar initially invested over a specified period of time. It is calculated by dividing the (total, not annualized) percentage retum by 100 and adding 1. For example, if the 10year return to a portfolio is 250%, its wealth relative is 3.50, which means tiiat for every dollar invested ten years previously, the investor now has $3.50. YieldNormally the dividend paid annually on a stock divided by its price. For a bond, current yield would be die identical calculation, i.e., the annual interest payment divided by the current price, while yield to maturity would measure all interest payments to maturity over the current price. ZeroCoupon BondA security tiiat pays no interest, but instead is sold at discounts large enough to include the interest rate over the life of the bond. The zerocoupon bond allows investors to lock in the interest rate for long periods, if rates are high. Thus if yields rose to 10%, the investor would receive not only the 10% on the principal of the bond, but also would have all the interest to maturity reinvested at this rate. For a longterm bond the difference in reinvesting the interest at higher rates can be considerable.
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