When comparing one investment strategy with another one, the issue of risk is always hovering on the horizon. But how exactly can risk be measured? How can we quantify it to help us make better investment decisions? Most importantly, how can we measure portfolio performance?
At its ugly heart, risk is the probability of losing something that we value. Most of us value things such as emotional and physical health, friendship, etc. But what we will concern ourselves with today is financial risk.
An unexpected drop in the value of your investments can impact your emotional and physical health. This means that, when it comes to making investment decisions, there’s more at risk than just money. Risk itself is not unlike a dense fog. We know there’s something on the other side, but we’re not sure exactly what. And when it comes to our financial wellbeing, that’s the exact opposite of what we want.
That is why modern-day financial experts have developed metrics to analyze risk in just about every imaginable way. Yet the quantification techniques they have developed to measure and predict risk are still not perfect. This is why there are still so many statistical models out there. Most are useful under a particular set of circumstances. However, there is not one metric that can answer all risk-related questions all the time.
Learning which one is best given your particular situation can make the difference between being a winner or a loser. Here we review numerous ways you can measure your portfolio performance.
Risk versus Reward
Risk and reward are two sides of the same coin. When it comes to building an investment portfolio, we can never have rewards without accepting risks. The higher the potential rewards of a specific investment strategy, the higher the risks involved would typically be.
The question inevitably arises: What is the best option for a specific investor, a high risk/high reward approach, or a low risk/low reward one?
The answer is that one has to do a risk/reward analysis before every major new investment.
What is important to remember here is that, when you have to compare different investment options, using a variety of risk/reward assessment techniques can help to get a much clearer picture than if you focused on only one or two.
Let’s first look at a simple technique that forms part of several investment portfolio metrics:
In the world of investing, the technique of comparing one investment to another by using a predetermined index is referred to as benchmarking. The aim here is to offer a common yardstick to compare a variety of investment products or portfolios.
If all of this is starting to sound terribly technical, don’t worry too much. It’s not really that complex. Benchmarks are actually just unmanaged investment portfolios that ‘blindly’ follow price movements in a particular market segment. Two examples include the FTSE 100 and the S&P 500.
The benchmark you use to evaluate an investment portfolio or fund must contain a relevant mix of assets. In other words: make sure you compare apples with apples. You typically shouldn’t use an index based on manufacturing stock prices to evaluate a portfolio that consists solely of financial stocks.
The Importance of Understanding Both Reward and Risk
Most investors intuitively understand the return side of an investment portfolio. For example, an investment that makes a return of 10 per cent a year is ‘better’ than one that makes 5 per cent. When it comes to comparing the risks involved with different investment portfolios, however, the situation is much more complex.
To really make an informed investment decision though, it is imperative to combine risk and reward in a single metric.
Below we examine a number of core metrics that can assist us to gain a crucial perspective on the true portfolio performance or fund performance relative to various benchmarks.
Nine Important Portfolio Benchmarks
This metric compares portfolio performance (after making adjustments for risk) to that of the benchmark. It is widely used to measure the value added by the fund or portfolio manager.
Alpha attempts to assign a monetary value to a portfolio or fund manager’s ability to produce risk-adjusted returns that compare favorably to the benchmark. This metric is also known as ‘active return’ and is typically quoted as a percentage.
A negative Alpha is an indication that the fund or portfolio is underperforming compared to the benchmark, for example the S&P 500. Conversly, a positive Alpha shows that it’s outperforming the benchmark.
Beta gives us an indication of an investment portfolio’s sensitivity to up or downswings. This again is relative to a given benchmark such as the FTSE 100. Similar to standard deviation, Beta is an indication of how volatile or stable an investment portfolio or fund is compared to the benchmark.
Let’s look at the example of an investment fund with a Beta of 1.15 relative to the Dow Jones. Based on historical data, this fund can be expected to be 15 per cent more volatile than the Dow Jones. On the other hand, a beta of 0.85 would mean it’s 15 per cent less volatile.
This metric is used to give investors an insight into how much individual values differ from the distribution mean. Expressed as a percentage, standard deviation is often used to depict the volatility of an investment fund, portfolio, or investment product compared to the benchmark. It can also help to uncover trends that are useful for forecasting purposes.
A stock with a high standard deviation will, for example, typically undergo much bigger up and downswings than one with a lower standard deviation. The latter will generally speaking have fewer sharp, unpredictable price movements.
This ratio is the brainchild of Nobel laureate William F. Sharpe who developed it specifically to be used as a measurement of an investment portfolio’s risk-adjusted performance.
To calculate the Sharpe Ratio, one starts with the rate of return for the portfolio you want to evaluate. From that, you deduct the risk-free rate of return, for example, that on 10-year U.S. Treasury bonds. The next step is to divide the result by the portfolio return’s standard deviation.
The Sharpe Ratio is a good indication of how much investors could be rewarded for taking on the added risk of investing in a particular portfolio or fund. This is taken from the view as an ROI, or Return On Investment.
This metric gives an indication of how closely a portfolio’s price movements are following the benchmark. It does so by measuring what percentage of the portfolio’s up- or downswings can be traced back to price movements in the benchmark index.
R-squared can have values that range anywhere between 0 and 1. These are typically expressed as percentages. An R-square of 80% means that 80% of the fund’s or portfolio’s price movements can be traced back to movements in the benchmark, e.g. the S&P 500.
If the R-Squared is high, let’s say between 85% and 100%, it shows that the fund or portfolio performance is closely linked to the index’s price movements. Conversely, if a fund has a low R-Squared (let’s say less than 70%), it’s an indication that the fund or portfolio doesn’t closely follow the price movements of the index.
It is sometimes very very useful to exclude price increases when measuring risk. This ratio does this by focusing on downward price movements instead of general volatility, as in the impact of price increases is removed.
A higher Sortino ratio, therefore, points to a higher return (after adjusting for risk), while a lower Sortino ratio points to a lower return (also after making adjustments for risk).
One has to remember, however, that in order to calculate Sortino ratios there must be enough negative returns. Since these are not always available and because volatility is often fairly symmetrical, the original Sharp ratio is often preferred by analysts.
Although similar to the Sortino and Sharpe ratios, this ratio follows a somewhat different approach to calculate risk-adjusted returns. It compares the extent to which a fund or portfolio’s returns exceed the risk-free rate with that fund/portfolio’s Beta.
A higher Treynor ratio represents a relatively high risk-adjusted return. Conversely, a lower Treynor ratio represents a lower-risk-adjusted return.
Like the Sharpe and Sortino ratios, the Treynor ratio on its own is not very useful. It is best used in combination with one or more other metrics.
This metric provides a statistical measure of the amount of risk involved with a specific portfolio.
The definition says it provides a measure of the maximum amount one can expect a specific portfolio to lose during a given period, e.g. a year, at a pre-defined level of confidence.
If the 90% 1-year Value-At-Risk for example is $2 million, an investor can be 90% sure that over the next year this particular investment portfolio will not lose more than $2 million.
One can use different techniques to calculate VAR. Under the historical method, it is calculated by using the returns that belong to the bottom quintile of the series, as measured by the confidence level, and looking at the highest of those returns.
With the parametric method, Value-At-Risk is calculated as a function of the variance and the mean of the series of returns (given a normal distribution).
Under the variance-covariance method, VAR is computed as a function of the mean and variance of the returns series, assuming a normal distribution.
The Monte Carlo method, on the other hand, simulates many different scenarios for the investment portfolio. It also calculates Value-At-Risk by noting the distribution of these various paths.
This metric provides a fairly simple indication of risk that is both easy to understand and quite intuitive. It simply measures the biggest top-to-bottom decline that an investment portfolio or fund experienced during a given time. This is expressed in the form of a percentage that shows the biggest single price drop from a new high.
A lower Maximum Drawdown is, therefore, an indication of lower risk. Conversely, a higher Maximum Drawdown is a warning that the portfolio or strategy comes with higher risk.
The downside of the Maximum Drawdown metric is that it doesn’t give any indication as to how frequently similar declines can be expected. Although it does highlight the biggest single decline.
By using Maximum Drawdown in tandem with some or other measure of volatility, for example the Standard Deviation, you can get a better idea of the real risks involved.
The nine metrics discussed above do not represent a comprehensive list of all the ways one can use to measure portfolio performance. Understanding the basic principles mentioned above will, however, help you to get a clearer picture of an investment fund or portfolio’s past performance and of what can be expected in the future. Just keep in mind that past portfolio performance does not necessarily guarantee future outcomes.