When posed with the question of how their investment portfolio has done, usual answers would centre around a certain XX % return over a period of YY years. However, this approach is only one approach to measure performance, and investors may lose out in the long run if they don’t understand other dimensions of investment performance.
Returns Alone Are Not The Full Picture
Consider this scenario: Two people come asking you for money to invest. One of them tells you that he can make 50% in one year, while the other says he can make 25% in the same period of time. Obviously you would invest with the first guy right? Not necessarily.
Let’s add a couple more details: The first guy says that the maximum possible loss would be 75%, while that for the second guy is 10%. Given this scenario, more would be inclined to invest with the second guy instead – because the potential reward per unit of possible loss is higher.
It should be clear by now that just looking at returns alone may not be a true reflection of your portfolio. If you knew that you were risking a 50% possible drawdown with only a 20% upside, would you still invest the same way?
Common Portfolio Performance Concepts
Measuring Risk – Professionals in the financial industry look at risk from a statistical standpoint, ie. More risk means more uncertainty. Thus risk is measured by volatility, or standard deviation in statistical terms.
Sharpe Ratio – We won’t go heavily into the math here, but this is the number one way the industry measures fund performance. One basic interpretation is simply dividing the portfolio return by the volatility. Sharpe ratios are typically only good above 1 (since your risk/reward is favourable). If you find that year after year, your sharpe ratio is below 1, you may wish to modify your investing approach (usual suspects are investments in stocks with extremely high volatility).
Beta – This term is commonly used in the financial industry as a reference to the broad stock market. Thus, if your portfolio returns closely mirror the STI, your portfolio is said to have a high beta. Beta can take on a huge range of values, from negative to positive.
Jensen’s Alpha – Building on the concept of beta, one way to measure fund manager competence (especially for long-only equity funds) is to measure how much of the performance is NOT attributable to the broad stock market. Again, a quick dirty calculation would simply be taking portfolio performance and deducting (beta of your portfolio x overall market return). This is a quick way to quantify your “value investing” prowess. It even helps when evaluating other managers’ performance, as it helps you to tell who was good at stock picking vs. someone who just got lucky going long the market.
Like all approximations in life, these metrics help tell a story about your portfolio performance. Nonetheless it should be noted that since you are using historical performance for their calculation, be aware that the past can help to provide a credible but incomplete picture about the future. As the maxim goes, “Past performance is not indicative of future results”.
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