Glossary

A

Active management

An investment management approach where a manager aims to beat the market through research, analysis and their own judgement. The term is often contrasted with ‘passive management’.

Active share

A measure of how actively a fund is managed reached by analysing the degree to which the weightings of that fund’s holdings differ from those of its benchmark index.

Affect heuristic

Where people’s likes, desires and other emotions influence what they believe or how they think about the world – for example, football fans betting on England winning a major tournament regardless of the actual odds.

Amortisation

Similar to depreciation, this is the practice of reflecting the decreasing value of an asset over time by reducing its value in a company’s accounts. However, while depreciation is used in relation to tangible assets, such as a building, amortisation is used in relation to intangible assets, such as goodwill.

Anchoring

A behavioural finance bias where a person’s decisions are influenced by the value they originally attached to something – for example, an investment. Essentially they are basing or ‘anchoring’ their perceptions on the current environment rather than recognising that something entirely different could happen in the future.

Averaging down

Also known as ‘doubling down’, this is the process of acquiring further shares in a company after its price has fallen because you believe in the long-term investment case for the business. This process of buying more shares at a lower price than your original purchase brings down the average price you have paid for the total number of shares you now own – hence the name.

Availability heuristic

Also known as ‘recency bias’, this is the behavioural finance idea that humans tend to ascribe greater significance to more recent events – for example, a driver immediately slowing down after being surprised by a speed camera only to accelerate a few miles further down the road.

B

Behavioural finance biases

Tendencies in human beings to think in certain ways and take certain decisions that have more to do with instinct than rationality or good judgement. Rarely conducive to sound investment, these cognitive biases include ‘anchoring’, ‘framing’ and ‘herding’.

Benchmark

A standard – usually an index or a market average – against which an investment fund’s performance can be measured. Many funds are managed with reference to a stated benchmark.

Book value

The value of a company’s assets minus its liabilities.

C

Capital allocation

The different ways in which a business will prioritise and direct its financial resources – for example, by investing in future growth or returning cash to shareholders through dividends and share buybacks.

Core tier 1 ratio

A measure of a bank’s financial strength – obtained by dividing a bank’s core equity by its risk-weighted assets – that indicates how safe or otherwise it should be as an investment. A larger number indicates greater financial strength.

Correlation

A measure of how securities or asset classes move in relation to each other. Highly correlated investments will tend to move up and down together while investments with a low correlation will tend to perform in different ways in different market conditions, providing investors with diversification benefits. Correlation is measured between 1 (perfect correlation) and -1 (perfect opposite correlation). A correlation of 0 between two assets suggests no correlation exists.

Credit default swap (CDS)

A CDS is a derivative. It is a type of insurance against the default of debt. The buyer of a CDS pays a premium to a CDS seller in exchange for the insurance that if the debt defaults, the CDS seller will compensate them. The CDS seller is speculating against the risk of default and hopes to make a profit from the premium payments. The higher the risk of default, the higher the premium will be.

Credit rating agency

A company that assigns credit ratings to issuers of debt, such as governments or companies. The most well-known credit rating agencies are Fitch, Moody’s and Standard & Poor’s.

D

Derivatives

The collective name used for a broad class of financial instruments that derive their value from other underlying financial instruments. Futures, options and swaps are all types of derivative.

Developed markets

Countries that tend to be industrialised and have a high gross domestic product. Developed markets usually have high standards of living and stable economies and are generally considered to be less risky investment options than less developed or ‘emerging’ markets.

Discount rate

Linked to bond yields, this is a way of gaining some idea – in ‘today’s money’ terms – of how much a pension scheme will ultimately have to pay out to its members.

Diversification

The creation of a portfolio from a range of different assets. This reduces the risk of loss through exposure to any individual asset and can help to reduce overall portfolio risk where assets have a low correlation.

Dividend

A payment made by a company to its shareholders. The company decides how much the dividend will be and when it will be paid.

Dividend yield

The annual dividend per share divided by the current share price. This is useful for comparing investments – for example, if a company’s shares are trading at £100 and the annual dividend is £5, the dividend yield is 5%. However, if the company's shares are £200, the dividend yield is just 2.5%.

Doubling down

Also known as ‘averaging down’, this is the process of acquiring further shares in a company after its price has fallen because you believe in the long-term investment case for the business. This process of buying more shares at a lower price than your original purchase brings down the average price you have paid for the total number of shares you now own.

Downside

The potential loss for a given investment

E

Earnings per share (EPS)

An indication of a company’s profitability reached by dividing its net income by the number of shares in issue.

Earnings before interest and taxes (EBIT)

A measure of a business’s profits before interest and tax expenses are deducted.

Earnings before interest, taxes, depreciation and amortisation (EBITDA)

A measure of a business’s profits before interest, taxes, depreciation and amortisation are deducted. Since it takes away the effects of accounting and financing decisions, it is a popular way of comparing the profitability of different businesses or industry sectors.

Earnings growth

The percentage change in a company’s earnings per share, generally measured over one year.

Earnings per share

The profits of a company attributed to each share, calculated by dividing profits after tax by the number of shares in issue.

Earnings yield

The earnings per share of a company divided by its current market price.

Emerging markets

Countries that have rapidly growing economies and may be going through the process of industrialisation.

Enterprise value

A common way of measuring a business’s value, it is calculated by adding a company’s market capitalisation and its debt and other liabilities and then subtracting the cash on its balance sheet.

Equity

A share in the ownership of a company.

Extrapolation

In an investment context, making judgements about the future based on how things are in the present without acknowledging the possibility they could change materially going forward.

F

Fixed income

Securities, such as bonds, that carry a predetermined and fixed rate of interest (also known as a ‘coupon’). This may be contrasted with the variable return on equities.

Free cashflow

A measure of a business’s performance based on the cash it is able to generate after making sufficient provision for its future growth.

Free cashflow yield

A metric that standardises a company’s free cashflow to enable easier comparison with other businesses. It is reached by dividing a company’s free cashflow per share by its share price.

Framing

A behavioural finance bias that can lead people to react in different ways to the same information, depending on how that information is presented.

G

Gearing

See ‘leverage’.

Graham & Dodd ratios

Metrics such as price/earnings (P/E) or earnings per share (EPS) ratios that, rather than referring to a single year’s profit number, uses an average of 10 years to smooth out the inevitable peaks and troughs of a cycle.

Gross domestic product (GDP)

The total value of all the goods and services produced in a country within a given period.

H

Hedge fund

A collective name for funds targeting absolute returns through investment in financial markets and/or applying non-traditional portfolio management techniques. Hedge funds can invest using a broad range of strategies.

Heuristics

Mental rules of thumb or short cuts developed over many millennia where the human brain sacrifices intellectual rigour for the sake of reaching a speedier decision. Such behavioural finance biases can often lead to poor investment decisions.

Herding

A behavioural finance bias that can lead investors to follow the crowd because they are either scared of missing out or being left exposed. Herding can be a cause of pricing bubbles, such as in the technology boom at the turn of the millennium.

I

Inflation

A measure of the increase in prices of goods and services over time.

Information ratio

A measure of how well a manager has performed relative to the level of risk they have taken.

Initial public offering (IPO)

The same as a floatation, this is the launch of a company on a stockmarket, making its shares available to the public.

Interest rate

The amount charged by a lender to a borrower for the use of cash or other assets and expressed as a percentage of the total amount lent. Central banks set indicative interest rates and these can have a significant effect on the performance of a country’s overall economy.

L

Leverage

Also known as ‘gearing’, this can refer to the amount a company is funded through borrowing – in other words, how much money it owes compared with how much money or assets it owns. However, the term can also refer to a fund being exposed by more than 100% of its net asset value to assets or markets. The aim here may be to take on more risk in order to generate higher returns, or it may actually be to reduce risk in the portfolio.

Leverage ratio

A measure of a bank’s financial strength – obtained by dividing a bank’s core equity by its un-weighted assets – that indicates how safe or otherwise it should be as an investment.

Liquidity

The ease with which an asset can be sold for cash. An asset can be described as illiquid if it is difficult to find someone willing to buy it or if, like property, it takes a long time to sell.

Long/short strategy

A strategy, used primarily by hedge funds, that involves taking long positions (buying a holding) in stocks that are expected to increase in value and short positions (borrowing a stock you do not own and selling it in the hope of repurchasing it at a lower price to return to the stock lender) in stocks that are expected to decrease in value.

M

Macroeconomic

A term referring to the behaviour and drivers of an economy as a whole and taking into account such factors as inflation, interest rates and unemployment. Its opposite is ‘microeconomic’, which refers to the behaviour of small economic units, such as individual consumers or households.

Market capitalisation

A measure of a company’s size, calculated by multiplying the total number of shares in issue by the current share price. Companies are commonly grouped according to size as ‘large cap’, ‘mid cap’ or ‘small cap’ although there is no consensus on the precise monetary boundaries of these ranges.

Momentum investing

An investment strategy based on the idea perceived trends – for example, rising or falling share prices – are more likely to continue than reverse. Momentum investors try to make gains by buying shares that are going up in value, as they believe the share price will continue to rise.

Mutual fund

A professionally managed collective investment scheme that pools money from a large number of investors.

O

Overconfidence

In behavioural finance terms, this is an unwarranted belief, either of an individual or a company, in the scope of their prospects or abilities – and particularly their ability to make reliable forecasts about their future.

P

Passive management

A style of investment management that aims to replicate the performance of a specific benchmark. The term is often contrasted with ‘active management’.

Price-to-book value

An analysis metric that compares a company’s share price with its book value.

Price-to-earnings (P/E) ratio

A ratio used to value a business that is calculated by dividing the current market price of a company by its earnings per share number.

Price-to-tangible-book value

An analysis expressing the price of a security compared to its hard (tangible), book value. The tangible book value number is equal to the company's total book value less the value of any intangible assets. Intangible assets can be such items as patents, intellectual property, goodwill etc.

R

Real return

The return generated by an investment after it has been adjusted for the effects of inflation. As an example, if an investment grew in value by 5% over one year and the rate of inflation was 2%, the real return would be 3%.

Real yield

The return on an investment minus the effect of inflation so, if the return on an investment is 7% with inflation at 3%, then the real yield is 4%.

Recency bias

See ‘availability heuristic’.

Relative Return

The return that an asset achieves over a period of time compared to a benchmark.

Return on equity (ROE)

A measure of the profitability of a company – effectively, how much profit a company generates with the money shareholders have invested. As an example, if a company’s equity is valued at £10m and it makes a profit of £1m, the return on equity is 10%.

Return on invested capital (ROIC)

A profitability measure that offers an indication of how good a business is at using its money to generate returns. The ROIC ratio can be calculated in a variety of ways – for example, by subtracting the dividends a company pays from its net (post-tax) income and then dividing that figure by its total amount of capital.

Reversion to the mean

The idea that while investment prices and returns can swing heavily up or down in the short term they will eventually move back or ‘revert’ to their historical average.

Risk premium

The extra return over cash an investor expects to earn as compensation for owning an investment that is not risk-free, meaning its value could go down as well as up.

S

Security

General term for an equity or debt instrument issued by a government or company.

Sharpe ratio

A measure of risk-adjusted performance. The higher the ratio, the better risk-adjusted performance has been.

Standard deviation

A measure of historical volatility. It is calculated by comparing the average return with the average variance from that return.

T

Tangible book value

A measure of a bank’s fair value – obtained by dividing a bank’s tangible net assets by the number of its shares in issue – that gives investors an idea of the changing upside in the business.

V

Value investing

A long-term investment strategy based on the fundamental analysis of companies, with a focus on valuation and balance sheet strength. It involves buying stocks trading for less than their intrinsic value and selling them when they are trading above their intrinsic value. This strategy is based on the belief markets tend to overreact to both good and bad news, thereby allowing value-oriented investors to take advantage of price distortions before prices revert back to fair, or intrinsic, value.

Volatility

A statistical measure of the fluctuations of a security’s price. It can also be used to describe fluctuations in a particular market. Volatility is often confused by investors as being a measure of risk. In reality, it reflects opportunity – if a stock is volatile, investors can take advantage of the sentiment and emotion that is causing the price to swing in excess of that warranted by fundamentals.

Y

Yield

A measure of the income return earned on an investment. In the case of a share, the yield is the annual dividend payment expressed as a percentage of the market price of the share. For property, it is the rental income as a percentage of the capital value. For bonds, the yield is the annual interest as a percentage of the current market price.