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Common Asset Allocation Terms

Part of the Asset Allocation For Dummies Cheat Sheet

You don’t need to be a professional analyst or experienced stock-picker to have better investment results than most investors. What you do need is an understanding of asset allocation. Here are some basic terms to get started:

  • Total return: Returns quoted in the press often focus strictly on growth (for example, “The S&P 500 is up 6 percent this year”). You want to know total return, which is the combination of income (interest from bonds or dividends from stocks) and growth.

  • Nominal returns: Returns that aren’t adjusted for inflation. Most returns presented are nominal returns.

  • Real returns: Returns that are adjusted (downward) for inflation.

  • Standard deviation: The most common measure of investment volatility; gauges how much an investment’s return varies over time from its long-term average.

  • Risk drag: Over realistic investment horizons (more than a year), an investment’s volatility can eat away at its return. This effect is called risk drag, and it’s a subtle but real phenomenon that you need to keep an eye on.

  • Perfect negative correlation: This is the holy grail of investing: finding a set of investments whose returns fluctuate in opposite directions from each other, to exactly the same degree every time. You won’t find it, but you can approach it, and it really will help reduce risk.

  • Efficient frontier: If you can’t improve a portfolio — in other words, it’s impossible to find another one of similar risk with a better return, or one of similar return with lower risk — then that portfolio is on the efficient frontier. The efficient frontier is a great place to be.

  • Rebalancing: Over time, your portfolio will drift away from its target allocation. Rebalancing is the process that brings it back into alignment. If you do it right, rebalancing can reduce the risk and increase the return of your portfolio.

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Asset Allocation For Dummies Cheat Sheet

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