Technical Analysis: Chart
Technical Analysis: Chart
Chart
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).
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
above the opening trade, the candlestick will usually be white or clear. If the stock has traded down for the period,
then the candlestick will usually be red or black, depending on the site. If the stock's price has closed above the
previous day’s close but below the day's open, the candlestick will be black or filled with the color that is used to
indicate an up day. (To read more, see The Art Of Candlestick Charting - Part 1, Part 2, Part 3 and Part 4.)
When first looking at a point and figure chart, you will notice a series of Xs and Os. The Xs represent upward price
trends and the Os represent downward price trends. There are also numbers and letters in the chart; these represent
months, and give investors an idea of the date. Each box on the chart represents the price scale, which adjusts
depending on the price of the stock: the higher the stock's price the more each box represents. On most charts where
the price is between $20 and $100, a box represents $1, or 1 point for the stock. The other critical point of a point and
figure chart is the reversal criteria. This is usually set at three but it can also be set according to the chartist's
discretion. 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, in other words, how much the price has to move in order for a column of Xs to become a
column of Os, or vice versa. When the price trend has moved from one trend to another, it shifts to the right, signaling
a trend change.
Types of Trend
There are three types of trend:
Uptrends
Downtrends
Sideways/Horizontal Trends As the names imply, when each successive peak and trough is higher, it's
referred to as an upward trend. If the peaks and troughs are getting lower, it's a downtrend. When there is
little movement up or down in the peaks and troughs, it's a sideways or horizontal trend. If you want to get
really technical, you might even say that a sideways trend is actually not a trend on its own, but a lack of a
well-defined trend in either direction. In any case, the market can really only trend in these three ways: up,
down or nowhere. (For more insight, see Peak-And-Trough Analysis.)
Trend Lengths
Along with these three trend directions, there are three trend classifications. A trend of any direction can be
classified as a long-term trend, intermediate trend or a short-term trend. In terms of the stock market, a
major trend is generally categorized as one lasting longer than a year. An intermediate trend is considered
to last between one and three months and a near-term trend is anything less than a month. A long-term
trend is composed of several intermediate trends, which often move against the direction of the major trend.
If the major trend is upward and there is a downward correction in price movement followed by a
continuation of the uptrend, the correction is considered to be an intermediate trend. The short-term trends
are components of both major and intermediate trends. Take a look a Figure 4 to get a sense of how these
three trend lengths might look.
Figure 4
When analyzing trends, it is important that the chart is constructed to best reflect the type of trend being
analyzed. To help identify long-term trends, weekly charts or daily charts spanning a five-year period are
used by chartists to get a better idea of the long-term trend. Daily data charts are best used when analyzing
both intermediate and short-term trends. It is also important to remember that the longer the trend, the more
important it is; for example, a one-month trend is not as significant as a five-year trend. (To read more,
seeShort-, Intermediate- And Long-Term Trends.)
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. Drawing a trendline is as simple as drawing a straight line that follows a general trend. These lines
are used to clearly show the trend and are also used in the identification of trend reversals.
As you can see in Figure 5, an upward trendline is drawn at the lows of an upward trend. This line
represents the support the stock has every time it moves from a high to a low. Notice how the price is
propped up by this support. This type of trendline helps traders to anticipate the point at which a stock's
price will begin moving upwards again. Similarly, 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. (To read more, see Support & Resistance Basics and Support And Resistance Zones - Part
1 and Part 2.)
Figure 5
Channels
A channel, or channel lines, is the addition of two parallel trendlines that act as strong areas of support and
resistance. The upper trendline connects a series of highs, while the lower trendline connects a series of
lows. A channel can slope upward, downward or sideways but, regardless of the direction, the interpretation
remains the same. Traders will expect a given security to trade between the two levels of support and
resistance until it breaks beyond one of the levels, in which case traders can expect a sharp move in the
direction of the break. Along with clearly displaying the trend, channels are mainly used to illustrate
important areas of support and resistance.
Figure 6
Figure 6 illustrates a descending channel on a stock chart; 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, and has
remained range-bound for several months. As long as the price does not fall below the lower line or move
beyond the upper resistance, the range-bound downtrend is expected to continue.
Chart Pattern
Both of these head and shoulders patterns are similar in that there are four main parts: two shoulders, a head and
aneckline. Also, each individual head and shoulder is comprised of a high and a low. For example, in the head and
shoulders top image shown on the left side in Figure 1, the left shoulder is made up of a high followed by a low. In
this pattern, the neckline is a level of support or resistance. Remember that an upward trend is a period of successive
rising highs and rising lows. The head and shoulders chart pattern, therefore, illustrates a weakening in a trend by
showing the deterioration in the successive movements of the highs and lows.
Figure 2
As you can see in Figure 2, this price pattern forms what looks like a cup, which is preceded by an upward trend. The
handle follows the cup formation and is formed by a generally downward/sideways movement in the security's price.
Once the price movement pushes above the resistance lines formed in the handle, the upward trend can continue.
There is a wide ranging time frame for this type of pattern, with the span ranging from several months to more than a
year.
Double Tops and Bottoms
This chart pattern is another well-known pattern that signals a trend reversal - it is considered to be one of the most
reliable and is commonly used. These patterns are formed after a sustained trend and signal to chartists that the
trend is about to reverse. The pattern is created when a price movement tests support or resistance levels twice and
is unable to break through. This pattern is often used to signal intermediate and long-term trend reversals.
Figure 3: A double top pattern is shown on the left, while a double bottom pattern is shown on the
right.
In the case of the double top pattern in Figure 3, the price movement has twice tried to move above a certain price
level. After two unsuccessful attempts at pushing the price higher, the trend reverses and the price heads lower. In
the case of a double bottom (shown on the right), the price movement has tried to go lower twice, but has found
support each time. After the second bounce off of the support, the security enters a new trend and heads upward.
(For more in-depth reading,
Triangles
Triangles are some of the most well-known chart patterns used in technical analysis. The three types of triangles,
which vary in construct and implication, are the symmetrical triangle, ascending and descending triangle. These chart
patterns are considered to last anywhere from a couple of weeks to several months.
Figure 4
The symmetrical triangle in Figure 4 is a pattern in which two trendlines converge toward each other. This pattern is
neutral in that a breakout to the upside or downside is a confirmation of a trend in that direction. In an ascending
triangle, the upper trendline is flat, while the bottom trendline is upward sloping. This is generally thought of as a
bullish pattern in which chartists look for an upside breakout. In a descending triangle, the lower trendline is flat and
the upper trendline is descending. This is generally seen as a bearish pattern where chartists look for a downside
breakout.
Figure 5
As you can see in Figure 5, there is little difference between a pennant and a flag. The main difference between
these price movements can be seen in the middle section of the chart pattern. In a pennant, the middle section is
characterized by converging trendlines, much like what is seen in a symmetrical triangle. The middle section on the
flag pattern, on the other hand, shows a channel pattern, with no convergence between the trendlines. In both cases,
the trend is expected to continue when the price moves above the upper trendline.
Wedge
The wedge chart pattern can be either a continuation or reversal pattern. It is similar to a symmetrical triangle except
that the wedge pattern slants in an upward or downward direction, while the symmetrical triangle generally shows a
sideways movement. The other difference is that wedges tend to form over longer periods, usually between three and
six months.
Figure 6
The fact that wedges are classified as both continuation and reversal patterns can make reading signals confusing.
However, at the most basic level, a falling wedge is bullish and a rising wedge is bearish. In Figure 6, we have a
falling wedge in which two trendlines are converging in a downward direction. If the price was to rise above the upper
trendline, it would form a continuation pattern, while a move below the lower trendline would signal a reversal
pattern.
Gaps
A gap in a chart is an empty space between a trading period and the following trading period. This occurs when there
is a large difference in prices between two sequential trading periods. For example, if the trading range in one period
is between $25 and $30 and the next trading period opens at $40, there will be a large gap on the chart between
these two periods. 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. Gaps generally show that something of significance has happened in the
security, such as a better-than-expected earnings announcement.
There are three main types of gaps, breakaway, runaway (measuring) and exhaustion. A breakaway gap forms at the
start of a trend, a runaway gap forms during the middle of a trend and an exhaustion gap forms near the end of a
trend.
Confusion can form with triple tops and bottoms during the formation of the pattern because they can look similar to
other chart patterns. After the first two support/resistance tests are formed in the price movement, the pattern will look
like a double top or bottom, which could lead a chartist to enter a reversal position too soon.
Rounding Bottom
A rounding bottom, also referred to as a saucer bottom, is a long-term reversal pattern that signals a shift from a
downward trend to an upward trend. This pattern is traditionally thought to last anywhere from several months to
several years.
Figure 8
A rounding bottom chart pattern looks similar to a cup and handle pattern but without the handle. The long-term
nature of this pattern and the lack of a confirmation trigger, such as the handle in the cup and handle, makes it a
difficult pattern to trade.
We have finished our look at some of the more popular chart patterns. You should now be able to recognize each
chart pattern as well the signal it can form for chartists. We will now move on to other technical techniques and
examine how they are used by technical traders to gauge price movements.
Types of Moving Averages
There are a number of different types of moving averages that vary in the way they are calculated, but how each
average is interpreted remains the same. The calculations only differ in regards to the weighting that they place on
the price data, 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, linear and exponential.
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. The critics argue that the most recent
data is more important and, therefore, it should also have a higher weighting. This type of criticism has been one of
the main factors leading to the invention of other forms of moving averages.
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. As you can see in Figure 3, when a moving average is heading
upward and the price is above it, the security is in an uptrend. Conversely, a downward sloping moving average with
the price below can be used to signal a downtrend.
Figure 3
Another method of determining momentum is to look at the order of a pair of moving averages. When a short-term
average is above a longer-term average, the trend is up. On the other hand, a long-term average above a shorter-
term average signals a downward movement in the trend.
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 first common signal is when the price moves through an
important moving average. For example, when the price of a security that was in an uptrend falls below a 50-period
moving average, like in Figure 4, it is a sign that the uptrend may be reversing.
Figure 4
The other signal of a trend reversal is when one moving average crosses through another. For example, as you can
see in Figure 5, if the 15-day moving average crosses above the 50-day moving average, it is a positive sign that the
price will start to increase.
Figure 5
If the periods used in the calculation are relatively short, for example 15 and 35, this could signal a short-term trend
reversal. On the other hand, when two averages with relatively long time frames cross over (50 and 200, for
example), this is used to suggest a long-term shift in trend.
Another major way moving averages are used is to identify support and resistance levels. 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.
A move through a major moving average is often used as a signal by technical traders that the trend is reversing. For
example, if the price breaks through the 200-day moving average in a downward direction, it is a signal that the
uptrend is reversing.
Figure 6
Moving averages are a powerful tool for analyzing the trend in a security. They provide useful support and resistance
points and are very easy to use. The most common time frames that are used when creating moving averages are
the 200-day, 100-day, 50-day, 20-day and 10-day. The 200-day average is thought to be a good measure of a trading
year, a 100-day average of a half a year, a 50-day average of a quarter of a year, a 20-day average of a month and
10-day average of two weeks.
Moving averages help technical traders smooth out some of the noise that is found in day-to-day price movements,
giving traders a clearer view of the price trend. So far we have been focused on price movement, through charts and
averages. In the next section, we'll look at some other techniques used to confirm price movement and patterns.
Oscillators
There are also two types of indicator constructions: those that fall in a bounded range and those that do not. The
ones that are bound within a range are called oscillators - these are the most common type of indicators. Oscillator
indicators have a range, for example between zero and 100, and signal periods where the security is overbought
(near 100) or oversold (near zero). Non-bounded indicators still form buy and sell signals along with displaying
strength or weakness, but they vary in the way they do this.
The two main ways that indicators are used to form buy and sell signals in technical analysis is
through crossoversand divergence. Crossovers are the most popular and are reflected when either the price moves
through the moving average, or when two different moving averages cross over each other.The second way
indicators are used is through divergence, which happens when the direction of the price trend and the direction of
the indicator trend are moving in the opposite direction. This signals to indicator users that the direction of the price
trend is weakening.
Indicators that are used in technical analysis provide an extremely useful source of additional information. These
indicators help identify momentum, trends, volatility and various other aspects in a security to aid in the technical
analysis of trends. It is important to note that while some traders use a single indicator solely for buy and sell signals,
they are best used in conjunction with price movement, chart patterns and other indicators.
Portfolio
Portfolio Theory
An investor might conclude that railroad stocks all offered good risk-reward characteristics and compile
a portfolio entirely from these. Intuitively, this would be foolish. Markowitz formalized this intuition.
Detailing a mathematics of diversification, 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. In a nutshell, inventors should select
portfolios not individual securities.
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, as well as the style of management that they use.
Although there are many general funds, such as segregated pension funds, that invest globally,
there is a continuing trend towards specialization in particular funds, such as segregated
pension funds, that invest globally, there is a continuing trend towards specialization in
particular markets, and each market will have its own principal considerations.
Equity management involves an element of asset allocation, either to countries managed by the
European, Far Eastern Latin America or Emerging Markets desks, or to industries within single countries,
especially within the UK. 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.
Since firms derive an increasing proportion of their earnings from countries outside their domicile, it is
becoming less and les relevant analyses them on the basis of economic prospects for that country (e.g.
GDP growth etc), More relevant are the issues facing each industry. Glaxo welcome have traditionally
derived the greatest proportion 9over 40%) of their earnings from overseas. Others, such as Vodafone,
are rapidly increasing the percentages earned outside the UK.
The number of different influences on a portfolio is quite diverse. 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, particularly useful are analyses of portfolio giving the weights allocated to each category, especially
where these weights are compared to the constituents of the index used as part or all of the fund’s bench
mark.
Other Analyses: Equities are sensitive to a number of different factors affecting their market prices in the
short, medium or long term. This means that the fund manager needs to look at his portfolio, and the
securities held in them, from a number of different perspectives and involves assimilating the huge
quantities of data available to fund managers, sourced from external brokers as well as their own firm’s
analysts. 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.
Company Size - In an economic upswing smaller companies may grow faster than larger firms, whilst in a
recession investors may prefer larger, more resilient (through cash availability or diversification )
companies .
Economics theme – E.g. Sensitive to oil prices, interest rates, factors affecting other economics in to
products are sold. Over all portfolio factors such as the fund’s beta can also provide useful risk
information. As with most types of fund level analysis, the comparison of the funds against the bench
mark is the most useful. 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- style manager ) or changing growth (if
you are growth manager ) .
If it is important to the fund manager that he receives dividends (eg if he is running an income fund), then
he might look at the ‘dividend cover ‘ , which is the ration of earnings per share over dividends per share
(ie, a measure of how easily a company can afford to pay the dividend ). Again, the trend of this over time
will be useful information.
1. The ability to derive above average returns for a given risk class (large risk-adjusted returns); and
2. the ability to completely diversify the portfolio to eliminate all unsystematic risk.
May also desire large real (inflation-adjusted) returns, maximization of current income, high after-tax rate
of return, preservation of capital.
Requirement #1 can be achieved either through superior timing or superior security selection. 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.
Conversely, a PM can try to select undervalued stocks or bonds for a given risk class.
Requirement #2 argues that one should be able to completely diversify away all unsystematic risk (as you
will not be compensated for it). You can measure the level of diversification by computing the correlation
between the returns of the portfolio and the market portfolio. A completely diversified portfolio correlated
perfectly with the completely diversified market portfolio because both include only systematic risk.
Some portfolio evaluation techniques measure for one requirement (high risk-adjusted returns) and not
the other; some measure for complete diversification and not the other; some measure for both, but don't
distinguish between the two requirements.
As late as the mid 1960s investors evaluated PM performance based solely on the rate of return. They
were aware of risk, but didn't know how to measure it or adjust for it. 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.
We shall look at some measures of composite performance that combine risk and return levels into a
single value.
This measure was developed by Jack Treynor in 1965. Treynor (helped developed CAPM) argues that,
using the characteristic line, one can determine the relationship between a security and the market.
Deviations from the characteristic line (unique returns) should cancel out if you have a fully diversified
portfolio.
Treynor's Composite Performance Measure: He was interested in a performance measure that would
apply to ALL investors regardless of their risk preferences. He argued that investors would prefer a CML
with a higher slope (as it would place them on a higher utility curve). 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 numerator represents the risk premium and the denominator
represents the risk of the portfolio; thus the value, T, represents the portfolio's return per unit of
systematic risk. All risk averse investors would want to maximize this value.
The Treynor measure only measures systematic risk--it automatically assumes an adequately diversified
portfolio.
You can compare the T measures for different portfolios. The higher the T value, the better the portfolio
performance. For instance, the T value for the market is:
In this expression, m = 1.
Demonstration of Comparative Treynor Measures: Assume that you are an administrator of a large
pension fund (i.e. Terry Teague of Boeing) and you are trying to decide whether to renew your contracts
with your three money managers. You must measure how they have performed. Assume you have the
following results for each individual's performance:
Z 0.12 0.90
B 0.16 1.05
Y 0.18 1.2
Tm (0.14-0.08)/1.00=0.06
TZ (0.12-0.08)/0.90=0.044
TB (0.16-0.08)/1.05=0.076
TY (0.18-0.08)/1.20=0.083
These results show that Z did not even "beat-the-market." Y had the best performance, and both B and Y
beat the market. [To find required return, the line is: .08 + .06(Beta).
One can achieve a negative T value if you achieve very poor performance or very good performance with
low risk. For instance, 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. If you have a negative beta portfolio and you earn a return higher than the risk-
free rate, then you would have a high T-value. Negative T values can be confusing, thus you may be
better off plotting the values on the SML or using the CAPM (in this case, .08+.06(Beta)) to calculate the
required return and compare it with the actual return.
It is VERY similar to Treynor's measure, except it uses the total risk of the portfolio rather than just the
systematic risk. The Sharpe measure calculates the risk premium earned per unit of total risk. In theory,
the S measure compares portfolios on the CML, whereas the T measure compares portfolios on the SML.
Demonstration of Comparative Sharpe Measures: Sample returns and SDs for four portfolios (and the
calculated Sharpe Index) are given below:
Portfolio Avg. Annual RofR SD of return Sharpe measure
Thus, portfolio O did the best, and B failed to beat the market. We could draw the CML given this
information: CML=.08 + (0.30)SD
Treynor Measure vs. Sharpe Measure. 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). If we had
a fully diversified portfolio, then both the Sharpe and Treynor measures should given us the same
ranking. A poorly diversified portfolio could have a higher ranking under the Treynor measure than for
the Sharpe 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:
Using this format, one would not expect an intercept in the regression. However, if we had superior
portfolio managers who were actively seeking out undervalued securities, they could earn a higher risk-
adjusted return than those implied in the model. So, if we examined returns of superior portfolios, they
would have a significant positive intercept. An inferior manager would have a significant negative
intercept. A manager that was not clearly superior or inferior would have a statistically insignificant
intercept. We would test the constant, or intercept, 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.
Applying the Jenson Measure. This requires that you use a different risk-free rate for each time interval
during the sample period. 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. Also, the Jensen measure does not evaluate the ability of the portfolio manager to diversify, as
it calculates risk premiums in terms of systematic risk (beta). For evaluating diversified portfolios (such a
most mutual funds) this is probably adequate. Jensen finds that mutual fund returns are typically
correlated with the market at rates above .90.
Calculated Sharpe, Treynor and Jenson measures for 20 mutual funds. Using the Jenson measure, only 3
managers had superior performance (Fidelity Magellan, Templeton Growth Funds, and Value Line
Special Situations Fund) while 2 managers had inferior performance (Oppenheimer Fund and T. Rowe
Price Growth Stock Fund).
For all three methods, if we are examining a well-diversified portfolio, the rankings should be similar. A
rank correlation measure finds that there is about a 90% correlation among all three measures. Reilly
recommends that all three measures. [In my opinion the Jensen measure is the most stringent. It is testing
for statistical significance, whereas the other methods are not. The other methods are also examining
average returns, whereas the Jensen measure uses actual returns during each observation period.]
You need to judge a portfolio manager over a period of time, not just over one quarter or even one year.
You need to examine the manager's performance during both rising and falling markets. There are also
other problems associated with these measures:
Measurement Problems: All of these measures are based on the CAPM. Thus, we need a real world
proxy for the theoretical market portfolio. Analysts typically use the S&P500 Index as the proxy;
however, it does not constitute a true market portfolio. It only includes common stocks trading on the
NYSE. Roll, in his 1980/1981 papers, calls this benchmark error.
We use the market portfolio to calculate the betas for the portfolios. Roll argues that if the proxy used for
the market portfolio is inefficient, the betas calculated will be inappropriate. The true SML may actually
have a higher (or lower) slope. Thus, if we plot a security that lies above the SML it could actually plot
below the "true" SML.
Global Investing: Incorporating global investments (with their lower coefficients of correlation) will
surely move the efficient frontier to the left, thus providing diversification benefits. It may also shift the
efficient frontier upward (increasing returns). [However, we have no proxy to measure global markets.]