How to evaluate your Portfolio performance
We call determining the performance of a specific investment portfolio relative to certain benchmarks “portfolio performance evaluation.” The assessment can indicate the extent to which the portfolio’s performance is better or lower. It also determines whether the performance is comparable to the benchmark.
Most investors judge the success of their portfolios based on returns. However, it is not enough. We need to calculate the portfolio’s performance to understand how our portfolio is diversified and how many risks we take. In other words, we need to measure not only the returns but risks as well.
Before the 1960s, no one has noticed the risks while getting rewards. However, today we have several portfolio performance evaluations and calculation methods that help us determine risks and returns.
Our goal is to introduce these methods to you, which will help you understand and evaluate your portfolio.
Why is it essential to evaluate portfolio performance?
Still, why do we need no learn evaluating our portfolio performance? There are several reasons for it.
First, investors need to understand the relative performance of the portfolio. Performance evaluations must determine and provide accurate information to assists investors in assessing any need for rebalancing their investments. Second, portfolio management needs this information to evaluate the portfolio manager’s performance and determine the manager’s compensation.
Performance evaluation methods
Performance evaluation methods are usually divided into two categories, namely conventional methods and risk adjustment methods. The most widely used conventional methods include benchmark comparison and style comparison. The risk adjustment method regulates returns to reflect the difference in risk levels between the managed and benchmark portfolios.
Benchmark Comparison
The most straightforward conventional method is to compare the performance of the investment portfolio with broader market indexes. The most widely used market index in the United States is the Standard & Poor’s 500 Index. It measures the price movements of 500 US stocks compiled by Standard & Poors.
Suppose the investment portfolio’s return exceeds the return of the benchmark index measured in the same period. In that case, it is said that the investment portfolio has exceeded the benchmark index. Although this comparison with passive indicators is widespread in the investment field, it creates a particular problem. The risk level of the investment portfolio may be different from the risk level of the benchmark index portfolio. In the long run, higher risks should lead to correspondingly higher returns. The investment portfolio’s performance might be better than the benchmark investment portfolio. It may be because the risk of the investment portfolio is higher than the benchmark investment portfolio.
Style Comparison
The second conventional method of performance evaluation is called “style comparison.” It involves comparing the return of a portfolio with the return of a portfolio of similar investment styles. Although there are many investment methods, a standard method classifies investment methods into value and growth. The “value style” portfolio invests in undervalued companies based on criteria such as price-to-earnings ratios and price-to-earnings ratios. “Growth” portfolios invest in companies whose income and earnings are expected to be faster than ordinary companies.
We can compare the return of this investment portfolio with the return of a benchmark investment portfolio with a value style. Similarly, compare the growth portfolio with the growth benchmark index. Although the two portfolios’ styles may look similar, the risks of the two portfolios may be different. Likewise, the chosen benchmark may not be genuinely comparable because two matching style-oriented funds can change in many important ways.
Reilly and Norton provide an excellent solution to the use of benchmark portfolios, styles, and the problems associated with them. Sharpe (1992) and Christopherson (1995) developed methods to determine this style.
Risk-adjusted Methods
These methods adjust returns to account for the differences in risk levels between the managed and benchmark portfolios. There are several Risk-Adjusted methods. However, the most important ones are the Sharpe ratio, Treynor ratio, and Jensen’s Alpha. Let’s discuss each of them.
Sharpe Ratio
Sharpe ratio is the most famous performance measure. It is defined as:
SR=(rp−rf )/σp
rp, σp, and rf are return and standard deviation of portfolio and the risk-free return over the noted period.
Generally, we use the Sharpe Ratio to state in annual terms.
Treynor Ratio
The asset’s Beta coefficient measures risk for a single investment better than the asset’s standard deviation.
TR=(rp−rf)/βp
βp is the portfolio’s beta coefficient, and the others are the same, as defined earlier.
Generally, a higher TR ratio is better.
Jensen’s Alpha
Jensen’s Alpha calculates the expected return to the portfolio adjusted for the return earned for taking risks.
α=rp−βp(rm−rf)
rm is here means the return on the market portfolio. Again, the larger the Alpha, the better.
To conclude, we hope the brief information we provided will help you evaluate your portfolio better.
