Technical Analysis


In technical analysis, charts are similar to the charts that you see in any business setting. A chart is simply a graphical representation of a series of prices over a set time frame. For example, a chart may show a stock's price movement over a one-year period, where each point on the graph represents the closing price for each day the stock is traded:

Figure 1
Figure 1 provides an example of a basic chart. It is a representation of the price movements of a stock over a 1.5 year period. The bottom of the graph, running horizontally (x-axis), is the date or time scale. On the right hand side, running vertically (y-axis), the price of the security is shown. By looking at the graph we see that in October 2004 (Point 1), the price of this stock was around $245, whereas in June 2005 (Point 2), the stock's price is around $265. This tells us that the stock has risen between October 2004 and June 2005. Chart Properties There are several things that you should be aware of when looking at a chart, as these factors can affect the information that is provided. They include the time scale, the price scale and the price point properties used.

Types of Chart
Line Chart The most basic of the four charts is the line chart because it represents only the closing prices over a set period of time. The line is formed by connecting the closing prices over the time frame. Line charts do not provide visual information of the trading range for the individual points such as the high, low and opening prices. However, the closing price is often considered to be the most important price in stock data compared to the high and low for the day and this is why it is the only value used in line charts.

Figure 1: A line chart
Bar Charts The bar chart expands on the line chart by adding several more key pieces of information to each data point. The chart is made up of a series of vertical lines that represent each data point. This vertical line represents the high and low for the trading period, along with the closing price. The close and open are represented on the vertical line by a horizontal dash. The opening price on a bar chart is illustrated by the dash that is located on the left side of the vertical bar. Conversely, the close is represented by the dash on the right. Generally, if the left dash (open) is lower than the right dash (close) then the bar will be shaded black, representing an up period for the stock, which means it has gained value. A bar that is colored red signals that the stock has gone down in value over that period. When this is the case, the dash on the right (close) is lower than the dash on the left (open).

Figure 2: A bar chart
Candlestick Charts The candlestick chart is similar to a bar chart, but it differs in the way that it is visually constructed. Similar to the bar chart, the candlestick also has a thin vertical line showing the period's trading range. The difference comes in the formation of a wide bar on the vertical line, which illustrates the difference between the open and close. And, like bar charts, candlesticks also rely heavily on the use of colors to explain what has happened during the trading period. A major problem with the candlestick color configuration, however, is that different sites use different standards; therefore, it is important to understand the candlestick configuration used at the chart site you are working with. There are two color constructs for days up and one for days that the price falls. When the price of the stock is up and closes

If the stock has traded down for the period. then the candlestick will usually be red or black. The point and figure chart removes the noise.) Figure 4: A point and figure chart When first looking at a point and figure chart. (To read more. depending on the site.Part 1. Part 3 and Part 4. see Point And Figure Charting. a box represents $1. Each box on the chart represents the price scale. you will notice a series of Xs and Os.) Figure 3: A candlestick chart Point and Figure Charts The point and figure chart is not well known or used by the average investor but it has had a long history of use dating back to the first technical traders. or insignificant price movements. which can distort traders' views of the price trends. which adjusts depending on the price of the stock: the higher the stock's price the more each box represents. This type of chart reflects price movements and is not as concerned about time and volume in the formulation of the points. (For further reading. the candlestick will usually be white or clear. in the stock. These types of charts also try to neutralize the skewing effect that time has on chart analysis. On most charts where the price is between $20 and $100. see The Art Of Candlestick Charting .above the opening trade. Part 2. the candlestick will be black or filled with the color that is used to indicate an up day. or 1 point for the stock. and give investors an idea of the date. There are also numbers and letters in the chart. The other critical point of a point and . If the stock's price has closed above the previous day¶s close but below the day's open. The Xs represent upward price trends and the Os represent downward price trends. these represent months.

A trend of any direction can be classified as a long-term trend. When there is little movement up or down in the peaks and troughs. the market can really only trend in these three ways: up. Types of Trend There are three types of trend: y y y Uptrends Downtrends Sideways/Horizontal Trends As the names imply. or vice versa. down or nowhere. The reversal criteria set how much the price has to move away from the high or low in the price trend to create a new trend or. A long-term trend is composed of several intermediate trends. If the peaks and troughs are getting lower. (For more insight. there are three trend classifications. but a lack of a well-defined trend in either direction.figure chart is the reversal criteria. signaling a trend change. it's a sideways or horizontal trend. a major trend is generally categorized as one lasting longer than a year. Figure 4 y . the correction is considered to be an intermediate trend. If the major trend is upward and there is a downward correction in price movement followed by a continuation of the uptrend. when each successive peak and trough is higher. it's referred to as an upward trend. how much the price has to move in order for a column of Xs to become a column of Os. see Peak-And-Trough Analysis.) Trend Lengths Along with these three trend directions. The short-term trends are components of both major and intermediate trends. in other words. which often move against the direction of the major trend. intermediate trend or a short-term trend. Take a look a Figure 4 to get a sense of how these three trend lengths might look. In any case. This is usually set at three but it can also be set according to the chartist's discretion. An intermediate trend is considered to last between one and three months and a near-term trend is anything less than a month. it's a downtrend. When the price trend has moved from one trend to another. If you want to get really technical. you might even say that a sideways trend is actually not a trend on its own. it shifts to the right. In terms of the stock market.

in which case traders can expect a sharp move in the direction of the break. regardless of the direction.When analyzing trends.) Figure 5 y Channels A channel. weekly charts or daily charts spanning a five-year period are used by chartists to get a better idea of the long-term trend. it is important that the chart is constructed to best reflect the type of trend being analyzed. the interpretation remains the same. the more important it is. To help identify long-term trends. channels are mainly used to illustrate important areas of support and resistance. seeShort-.Part 1 and Part 2. Notice how the price is propped up by this support. for example. As you can see in Figure 5. Drawing a trendline is as simple as drawing a straight line that follows a general trend. The upper trendline connects a series of highs. an upward trendline is drawn at the lows of an upward trend. Traders will expect a given security to trade between the two levels of support and resistance until it breaks beyond one of the levels. a downward trendline is drawn at the highs of the downward trend. This line represents the resistance level that a stock faces every time the price moves from a low to a high. is the addition of two parallel trendlines that act as strong areas of support and resistance. It is also important to remember that the longer the trend. These lines are used to clearly show the trend and are also used in the identification of trend reversals.) Trendlines A trendline is a simple charting technique that adds a line to a chart to represent the trend in the market or a stock. Similarly.And Long-Term Trends. while the lower trendline connects a series of lows. A channel can slope upward. downward or sideways but. This type of trendline helps traders to anticipate the point at which a stock's price will begin moving upwards again. Daily data charts are best used when analyzing both intermediate and short-term trends. or channel lines. (To read more. . This line represents the support the stock has every time it moves from a high to a low. Intermediate. see Support & Resistance Basics and Support And Resistance Zones . (To read more. Along with clearly displaying the trend. a one-month trend is not as significant as a five-year trend.

Head and shoulders bottom. . and has remained range-bound for several months. the range-bound downtrend is expected to continue. Chart Pattern Head and Shoulders This is one of the most popular and reliable chart patterns in technical analysis. the upper trendline has been placed on the highs and the lower trendline is on the lows. The price has bounced off of these lines several times.Figure 6 y Figure 6 illustrates a descending channel on a stock chart. The Importance of Trend It is important to be able to understand and identify trends so that you can trade with rather than against them. As you can see in Figure 1. Two important sayings in technical analysis are "the trend is your friend" and "don't buck the trend. there are two versions of the head and shoulders chart pattern. As long as the price does not fall below the lower line or move beyond the upper resistance." illustrating how important trend analysis is for technical traders. Head and shoulders is a reversal chart pattern that when formed. signals that the security is likely to move against the previous trend. but is used to signal a reversal in a downtrend. also known as inverse head and shoulders (shown on the right) is the lesser known of the two. Head and shoulders top (shown on the left) is a chart pattern that is formed at the high of an upward movement and signals that the upward trend is about to end.

There is a wide ranging time frame for this type of pattern. illustrates a weakening in a trend by showing the deterioration in the successive movements of the highs and lows. the upward trend can continue. a head and aneckline. The handle follows the cup formation and is formed by a generally downward/sideways movement in the security's price. In this pattern. with the span ranging from several months to more than a year. Head and shoulders bottom. or inverse head and shoulders. The head and shoulders chart pattern. . For example. the left shoulder is made up of a high followed by a low. each individual head and shoulder is comprised of a high and a low. therefore. in the head and shoulders top image shown on the left side in Figure 1. which is preceded by an upward trend. Cup and Handle A cup and handle chart is a bullish continuation pattern in which the upward trend has paused but will continue in an upward direction once the pattern is confirmed. Both of these head and shoulders patterns are similar in that there are four main parts: two shoulders. Remember that an upward trend is a period of successive rising highs and rising lows. the neckline is a level of support or resistance. this price pattern forms what looks like a cup. Once the price movement pushes above the resistance lines formed in the handle. is on the right.Figure 1: Head and shoulders top is shown on the left. Figure 2 As you can see in Figure 2. Also.

Figure 3: A double top pattern is shown on the left. After two unsuccessful attempts at pushing the price higher. the price movement has tried to go lower twice.Double Tops and Bottoms This chart pattern is another well-known pattern that signals a trend reversal . are the symmetrical triangle. In the case of a double bottom (shown on the right). but has found support each time. (For more in-depth reading. while a double bottom pattern is shown on the is considered to be one of the most reliable and is commonly used. . the security enters a new trend and heads upward. the price movement has twice tried to move above a certain price level. ascending and descending triangle. In the case of the double top pattern in Figure 3. The pattern is created when a price movement tests support or resistance levels twice and is unable to break through. After the second bounce off of the support. These chart patterns are considered to last anywhere from a couple of weeks to several months. These patterns are formed after a sustained trend and signal to chartists that the trend is about to reverse. which vary in construct and implication. Triangles Triangles are some of the most well-known chart patterns used in technical analysis. This pattern is often used to signal intermediate and long-term trend reversals. the trend reverses and the price heads lower. The three types of triangles.

The main difference between . the lower trendline is flat and the upper trendline is descending. Figure 5 As you can see in Figure 5. The patterns are generally thought to last from one to three weeks. In an ascending triangle. while the bottom trendline is upward sloping. In a descending triangle. This is generally thought of as a bullish pattern in which chartists look for an upside breakout. This pattern is neutral in that a breakout to the upside or downside is a confirmation of a trend in that direction. there is little difference between a pennant and a flag.Figure 4 The symmetrical triangle in Figure 4 is a pattern in which two trendlines converge toward each other. Flag and Pennant These two short-term chart patterns are continuation patterns that are formed when there is a sharp price movement followed by a generally sideways price movement. the upper trendline is flat. This is generally seen as a bearish pattern where chartists look for a downside breakout. This pattern is then completed upon another sharp price movement in the same direction as the move that started the trend.

The other difference is that wedges tend to form over longer periods. with no convergence between the trendlines. For example. It is similar to a symmetrical triangle except that the wedge pattern slants in an upward or downward direction. These are not as prevalent in charts as head and shoulders and double tops and bottoms. In a pennant. shows a channel pattern. A breakaway gap forms at the start of a trend. at the most basic level. Gap price movements can be found on bar charts and candlestick charts but will not be found on point and figure or basic line charts. usually between three and six months. a runaway gap forms during the middle of a trend and an exhaustion gap forms near the end of a trend. Wedge The wedge chart pattern can be either a continuation or reversal pattern. the middle section is characterized by converging trendlines. There are three main types of gaps. on the other hand. there will be a large gap on the chart between these two periods. This occurs when there is a large difference in prices between two sequential trading periods. Gaps generally show that something of significance has happened in the security. this signals a reversal of the prior trend. Triple Tops and Bottoms Triple tops and triple bottoms are another type of reversal chart pattern in chart analysis. but they act in a similar fashion. If the price was to rise above the upper trendline. a falling wedge is bullish and a rising wedge is bearish. much like what is seen in a symmetrical triangle. Figure 6 The fact that wedges are classified as both continuation and reversal patterns can make reading signals confusing.these price movements can be seen in the middle section of the chart pattern. . These two chart patterns are formed when the price movement tests a level of support or resistance three times and is unable to break through. the trend is expected to continue when the price moves above the upper trendline. breakaway. However. it would form a continuation pattern. while a move below the lower trendline would signal a reversal pattern. The middle section on the flag pattern. such as a better-than-expected earnings announcement. In Figure 6. Gaps A gap in a chart is an empty space between a trading period and the following trading period. In both cases. if the trading range in one period is between $25 and $30 and the next trading period opens at $40. we have a falling wedge in which two trendlines are converging in a downward direction. runaway (measuring) and exhaustion. while the symmetrical triangle generally shows a sideways movement.

. This pattern is traditionally thought to last anywhere from several months to several years. Rounding Bottom A rounding bottom. also referred to as a saucer bottom. Figure 8 A rounding bottom chart pattern looks similar to a cup and handle pattern but without the handle. is a long-term reversal pattern that signals a shift from a downward trend to an upward trend. You should now be able to recognize each chart pattern as well the signal it can form for chartists. such as the handle in the cup and handle. which could lead a chartist to enter a reversal position too soon. the pattern will look like a double top or bottom. makes it a difficult pattern to trade. After the first two support/resistance tests are formed in the price movement. The long-term nature of this pattern and the lack of a confirmation trigger.Figure 7 Confusion can form with triple tops and bottoms during the formation of the pattern because they can look similar to other chart patterns. We have finished our look at some of the more popular chart patterns. We will now move on to other technical techniques and examine how they are used by technical traders to gauge price movements.

in a 10-day moving average. in a five-day linear weighted average. For example. For example. the last 10 closing prices are added together and then divided by 10. therefore. The calculations only differ in regards to the weighting that they place on the price data. a 15-period EMA rises and falls faster than a 15-period SMA. Linear Weighted Average This moving average indicator is the least common out of the three and is used to address the problem of the equal weighting. This slight difference doesn¶t seem like much.Types of Moving Averages There are a number of different types of moving averages that vary in the way they are calculated. These numbers are then added together and divided by the sum of the multipliers. Figure 1 Many individuals argue that the usefulness of this type of average is limited because each point in the data series has the same impact on the result regardless of where it occurs in the sequence. a trader is able to make the average less responsive to changing prices by increasing the number of periods used in the calculation. yesterday's by four and so on until the first day in the period range is reached. Simple Moving Average (SMA) This is the most common method used to calculate the moving average of prices. . but it is an important factor to be aware of since it can affect returns. As you can see in Figure 2. Increasing the number of time periods in the calculation is one of the best ways to gauge the strength of the long-term trend and the likelihood that it will reverse. The most important thing to remember about the exponential moving average is that it is more responsive to new information relative to the simple moving average. today's closing price is multiplied by five. linear and exponential. The critics argue that the most recent data is more important and. but how each average is interpreted remains the same. As you can see in Figure 1. it should also have a higher weighting. This responsiveness is one of the key factors of why this is the moving average of choice among many technical traders. shifting from equal weighting of each price point to more weight being placed on recent data. The three most common types of moving averages are simple. The linear weighted moving average is calculated by taking the sum of all the closing prices over a certain time period and multiplying them by the position of the data point and then dividing by the sum of the number of periods. Exponential Moving Average (EMA) This moving average calculation uses a smoothing factor to place a higher weight on recent data points and is regarded as much more efficient than the linear weighted average. This type of criticism has been one of the main factors leading to the invention of other forms of moving averages. Having an understanding of the calculation is not generally required for most traders because most charting packages do the calculation for you. It simply takes the sum of all of the past closing prices over the time period and divides the result by the number of prices used in the calculation.

when a moving average is heading upward and the price is above it. a long-term average above a shorterterm average signals a downward movement in the trend. like in Figure 4. when the price of a security that was in an uptrend falls below a 50-period moving average. On the other hand. For example. it is a sign that the uptrend may be reversing. The first common signal is when the price moves through an important moving average. a downward sloping moving average with the price below can be used to signal a downtrend. Moving averages can be used to quickly identify whether a security is moving in an uptrend or a downtrend depending on the direction of the moving average. . Conversely. As you can see in Figure 3. Moving average trend reversals are formed in two main ways: when the price moves through a moving average and when it moves through moving average crossovers. the security is in an uptrend.Figure 2 Major Uses of Moving Averages Moving averages are used to identify current trends and trend reversals as well as to set up support and resistance levels. Figure 3 Another method of determining momentum is to look at the order of a pair of moving averages. the trend is up. When a short-term average is above a longer-term average.

For example. if the price breaks through the 200-day moving average in a downward direction. if the 15-day moving average crosses above the 50-day moving average. as you can see in Figure 5. . it is a positive sign that the price will start to increase. For example. when two averages with relatively long time frames cross over (50 and 200. this is used to suggest a long-term shift in trend. A move through a major moving average is often used as a signal by technical traders that the trend is reversing. it is a signal that the uptrend is reversing. Figure 5 If the periods used in the calculation are relatively short. On the other hand. for example). for example 15 and 35. It is not uncommon to see a stock that has been falling stop its decline and reverse direction once it hits the support of a major moving average.Figure 4 The other signal of a trend reversal is when one moving average crosses through another. Another major way moving averages are used is to identify support and resistance levels. this could signal a short-term trend reversal.

The most common time frames that are used when creating moving averages are the 200-day. Crossovers are the most popular and are reflected when either the price moves through the moving average. This signals to indicator users that the direction of the price trend is weakening. a 20-day average of a month and 10-day average of two weeks. and signal periods where the security is overbought (near 100) or oversold (near zero).The second way indicators are used is through divergence.Figure 6 Moving averages are a powerful tool for analyzing the trend in a security. The 200-day average is thought to be a good measure of a trading year. Oscillators There are also two types of indicator constructions: those that fall in a bounded range and those that do not. but they vary in the way they do this.these are the most common type of indicators. 50-day. through charts and averages. trends. for example between zero and 100. They provide useful support and resistance points and are very easy to use. Moving averages help technical traders smooth out some of the noise that is found in day-to-day price movements. 100-day. So far we have been focused on price movement. they are best used in conjunction with price movement. In the next section. which happens when the direction of the price trend and the direction of the indicator trend are moving in the opposite direction. The ones that are bound within a range are called oscillators . Indicators that are used in technical analysis provide an extremely useful source of additional information. . we'll look at some other techniques used to confirm price movement and patterns. chart patterns and other indicators. volatility and various other aspects in a security to aid in the technical analysis of trends. The two main ways that indicators are used to form buy and sell signals in technical analysis is through crossoversand divergence. Oscillator indicators have a range. Non-bounded indicators still form buy and sell signals along with displaying strength or weakness. 20-day and 10-day. These indicators help identify momentum. It is important to note that while some traders use a single indicator solely for buy and sell signals. giving traders a clearer view of the price trend. a 50-day average of a quarter of a year. or when two different moving averages cross over each other. a 100-day average of a half a year.

as well as the style of management that they use. that invest globally. there is a continuing trend towards specialization in particular funds. particularly useful are analyses of portfolio giving the weights allocated to each category. Markowitz formalized this intuition. This means that the fund manager needs to look at his portfolio. Although there are many general funds. such as segregated pension funds. Intuitively. inventors should select portfolios not individual securities. Equity management involves an element of asset allocation. More relevant are the issues facing each industry. especially within the UK. Glaxo welcome have traditionally derived the greatest proportion 9over 40%) of their earnings from overseas. and the . Detailing a mathematics of diversification. especially where these weights are compared to the constituents of the index used as part or all of the fund¶s bench mark. are rapidly increasing the percentages earned outside the UK.g. there is a continuing trend towards specialization in particular markets. that invest globally. either to countries managed by the European. In a nutshell. The number of different influences on a portfolio is quite diverse. Having said this internationalization of many companies in recent years has resulted in fund managers looking at industry grouping irrespective of the country in which the corporate is based. this would be foolish. Other Analyses: Equities are sensitive to a number of different factors affecting their market prices in the short. such as segregated pension funds. he proposed that investors focus on selecting portfolios based on their overall risk-reward characteristics instead of merely compiling portfolios from securities that each individually have attractive risk-reward characteristics. Since firms derive an increasing proportion of their earnings from countries outside their domicile. GDP growth etc). Portfolio construction The methodology used by fund managers to construct their portfolios will very much depend on the type of fund that they are managing. This Creates the need For a broad range of different analyses so that the fund manager can look at his portfolio broken down in different ways. such as Vodafone. Others.Portfolio Portfolio Theory An investor might conclude that railroad stocks all offered good risk-reward characteristics and compile a portfolio entirely from these. and each market will have its own principal considerations. Far Eastern Latin America or Emerging Markets desks. it is becoming less and les relevant analyses them on the basis of economic prospects for that country (e. or to industries within single countries. medium or long term.

a PM can try to select undervalued stocks or bonds for a given risk class. and 2. the trend of this over time will be useful information. from a number of different perspectives and involves assimilating the huge quantities of data available to fund managers. more resilient (through cash availability or diversification ) companies . Again. then he might look at the µdividend cover µ . whilst in a recession investors may prefer larger.securities held in manager ) or changing growth (if you are growth manager ) . Sensitive to oil prices. As with most types of fund level analysis. the ability to completely diversify the portfolio to eliminate all unsystematic risk. interest rates. Requirement #1 can be achieved either through superior timing or superior security selection. Economics theme ± E. A PM can select high beta securities during a time when he thinks the market will perform well and low (or negative) beta stocks at a time when he thinks the market will perform poorly. The Key is the interpretation of the data: what does the news imply for a security or overall industry grouping? Portfolio level analysis includes the following. which is the ration of earnings per share over dividends per share (ie. sourced from external brokers as well as their own firm¶s analysts. maximization of current income. May also desire large real (inflation-adjusted) returns. Conversely. Requirement #2 argues that one should be able to completely diversify away all unsystematic risk (as you will not be compensated for it). high after-tax rate of return. You can measure the level of diversification by computing the correlation between the returns of the portfolio and . preservation of capital. the comparison of the funds against the bench mark is the most useful. Over all portfolio factors such as the fund¶s beta can also provide useful risk information. If it is important to the fund manager that he receives dividends (eg if he is running an income fund). Portfolio performance evaluation We have two major requirements of a PM: 1. The ability to derive above average returns for a given risk class (large risk-adjusted returns). factors affecting other economics in to products are sold. Other security level analysis include the price to earning ratio growth which is a dynamic measure of a trend of changing value (if you are a value.g. Fund Break down By: Company Size .In an economic upswing smaller companies may grow faster than larger firms. a measure of how easily a company can afford to pay the dividend ).

the better the portfolio performance. You can compare the T measures for different portfolios. some measure for complete diversification and not the other. Treynor (helped developed CAPM) argues that. The slope of this portfolio possibility line is: A larger Ti value indicates a larger slope and a better portfolio for ALL INVESTORS REGARDLESS OF THEIR RISK PREFERENCES.the market portfolio. He argued that investors would prefer a CML with a higher slope (as it would place them on a higher utility curve). but don't distinguish between the two requirements. thus the value. They were aware of risk. Some portfolio evaluation techniques measure for one requirement (high risk-adjusted returns) and not the other. We shall look at some measures of composite performance that combine risk and return levels into a single value. some measure for both. Some investigators divided portfolios into similar risk classes (based upon a measure of risk such as the variance of return) and then compared the returns for alternative portfolios within the same risk class. A completely diversified portfolio correlated perfectly with the completely diversified market portfolio because both include only systematic risk. Treynor's Composite Performance Measure: He was interested in a performance measure that would apply to ALL investors regardless of their risk preferences. All risk averse investors would want to maximize this value. T. Composite Equity Portfolio Performance Measures As late as the mid 1960s investors evaluated PM performance based solely on the rate of return. the T value for the market is: . Deviations from the characteristic line (unique returns) should cancel out if you have a fully diversified portfolio. represents the portfolio's return per unit of systematic risk. For instance. The higher the T value. one can determine the relationship between a security and the market. but didn't know how to measure it or adjust for it. Treynor Portfolio Performance Measure (aka: reward to volatility ratio) This measure was developed by Jack Treynor in 1965. using the characteristic line. The numerator represents the risk premium and the denominator represents the risk of the portfolio. The Treynor measure only measures systematic risk--it automatically assumes an adequately diversified portfolio.

05 1.08)/1. then you would have a high T-value.00=0.16-0.08+.90=0. and both B and Y beat the market.12 0. For instance. [To find required return. thus you may be better off plotting the values on the SML or using the CAPM (in this case.044 (0.076 (0.16 0.2 You can calculate the T values for each investment manager: Tm TZ TB TY (0.08)/0.06 (0.06(Beta)) to calculate the required return and compare it with the actual return.083 These results show that Z did not even "beat-the-market.08 + .20=0. the line is: . Negative T values can be confusing. if you had a positive beta portfolio but your return was less than that of the risk-free rate (which implies you weren't adequately diversified or that the market performed poorly) then you would have a (-) T value." Y had the best performance.In this expression.06(Beta).e. It is as follows: . Sharpe Portfolio Performance Measure (aka: reward to variability ratio) This measure was developed in 1966. .18-0.14-0.08)/1. Demonstration of Comparative Treynor Measures: Assume that you are an administrator of a large pension fund (i.12-0. Terry Teague of Boeing) and you are trying to decide whether to renew your contracts with your three money managers. F m = 1.08)/1.05=0. One can achieve a negative T value if you achieve very poor performance or very good performance with low risk.18 Beta 0. Assume you have the following results for each individual's performance: Investment Manager Z B Y Average Annual Rate of Return 0. If you have a negative beta portfolio and you earn a return higher than the risk-free rate.90 1. You must measure how they have performed.

We could draw the CML given this information: CML=. Annual RofR 0. the S measure compares portfolios on the CML. Sharpe Measure.17 0. and B failed to beat the market. we get: Using this format.14 SD of return 0.278 0. In theory. A manager .18 0. However. Jenson Portfolio Performance Measure (aka differential return measure) This measure (as are all the previous measures) is based on the CAPM: We can express the expectations formula (the above formula) in terms of realized rates of return by adding an error term to reflect the difference between E(Rj) vs actual Rj: By subtracting the risk free rate from both sides.22 0. If we had a fully diversified portfolio.409 0. they would have a significant positive intercept.30)SD Treynor Measure vs. The Sharpe measure evaluates the portfolio manager on the basis of both rate of return and diversification (as it considers total portfolio risk in the denominator). portfolio O did the best.20 Sharpe measure 0.348 0.16 0.13 0. An inferior manager would have a significant negative intercept. A poorly diversified portfolio could have a higher ranking under the Treynor measure than for the Sharpe measure. The Sharpe measure calculates the risk premium earned per unit of total risk.30 Thus. So. if we had superior portfolio managers who were actively seeking out undervalued securities. except it uses the total risk of the portfolio rather than just the systematic risk. one would not expect an intercept in the regression.23 0. if we examined returns of superior portfolios.It is VERY similar to Treynor's measure.08 + (0. Demonstration of Comparative Sharpe Measures: Sample returns and SDs for four portfolios (and the calculated Sharpe Index) are given below: Portfolio B O P Market Avg. whereas the T measure compares portfolios on the SML. they could earn a higher risk-adjusted return than those implied in the model. then both the Sharpe and Treynor measures should given us the same ranking.

Reilly recommends that all three measures. or intercept. Application of Portfolio Performance Measures Calculated Sharpe. the betas calculated will be . in his 1980/1981 papers. Using the Jenson measure. whereas the Jensen measure uses actual returns during each observation period. whereas the other methods are not. Applying the Jenson Measure. A rank correlation measure finds that there is about a 90% correlation among all three measures. we need a real world proxy for the theoretical market portfolio. Thus. as it calculates risk premiums in terms of systematic risk (beta). It only includes common stocks trading on the NYSE. [In my opinion the Jensen measure is the most stringent. if we are examining a well-diversified portfolio. it does not constitute a true market portfolio. We use the market portfolio to calculate the betas for the portfolios. Relationship among Portfolio Performance Measures For all three methods. Also. This requires that you use a different risk-free rate for each time interval during the sample period. It is testing for statistical significance. You need to examine the manager's performance during both rising and falling markets. You must subtract the risk-free rate from the returns during each observation period rather than calculating the average return and average risk-free rate as in the Sharpe and Treynor measures. Roll.that was not clearly superior or inferior would have a statistically insignificant intercept. Roll argues that if the proxy used for the market portfolio is inefficient. the Jensen measure does not evaluate the ability of the portfolio manager to diversify. the rankings should be similar. Rowe Price Growth Stock Fund).] Factors that Affect Use of Performance Measures You need to judge a portfolio manager over a period of time. For evaluating diversified portfolios (such a most mutual funds) this is probably adequate. and Value Line Special Situations Fund) while 2 managers had inferior performance (Oppenheimer Fund and T. The other methods are also examining average returns. however. Jensen finds that mutual fund returns are typically correlated with the market at rates above . Templeton Growth Funds. only 3 managers had superior performance (Fidelity Magellan. calls this benchmark error. We would test the constant.90. not just over one quarter or even one year. in the following regression: This constant term would tell us how much of the return is attributable to the manager's ability to derive above-average returns adjusted for risk. Treynor and Jenson measures for 20 mutual funds. Analysts typically use the S&P500 Index as the proxy. There are also other problems associated with these measures:  Measurement Problems: All of these measures are based on the CAPM.

Thus. thus providing diversification benefits. we have no proxy to measure global markets. The true SML may actually have a higher (or lower) slope.inappropriate. It may also shift the efficient frontier upward (increasing returns).  Global Investing: Incorporating global investments (with their lower coefficients of correlation) will surely move the efficient frontier to the left.] . [However. if we plot a security that lies above the SML it could actually plot below the "true" SML.

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