One of the most important things to measure about any investment or portfolio is performance. How good are the returns? What numbers do professionals use to compare one investment with another?
We can consider investment performance on its own, compare it with investment risk, or assess the portfolio as a whole. The perfect portfolio does not exist, but when we compare portfolios with one another or with other benchmarks, we can start to see where they can be improved.
Considering Performance Alone
Before we can put investment performance into context, we first have to consider it by itself. Generally we start by considering past performance. Obviously it’s much easier to tell what an investment did earn than what it might earn later. Future performance is always more of a guess.
Return on investment (ROI) is the most basic measurement of past performance. You simply take the current value of the investment, subtract the beginning value, divide by the amount of the investment, and multiply by 100. That gives you a rate of return expressed as a percentage. You can also annualize it, by showing the return over an average year. This way, you can compare everything from the interest rate on savings accounts to the return on stocks. It’s important when calculating ROI to include everything you spent on the investment, including fees, and all profits, including dividends. That will make a more accurate ROI. If your advisor or broker offers an ROI number, ask if it includes fees.
What about future performance? For that, we’ll have to start factoring in risk. After all, we never know the future performance of an asset. We could simply assume it will continue to do as well as it has in the past. But, given some assets are highly volatile and don’t offer the same returns year to year, that would be a huge mistake.
Measuring Performance When Compared to Risk
Since understanding performance as compared to risk is so important, financial analysts have come up with many different formulas for this. Sharpe ratio, Treynor ratio, and Jensen’s alpha are three popular ones.
The Sharpe ratio takes a risk-free investment, such as a US treasury bond, and compares investments to it. In this way, we can see how much any given investment exceeds what a risk-free investment could do.
The formula is this: take the ROI of the investment in question, and subtract the ROI of the risk-free investment. Then divide that number by the standard deviation of the investment. Remember, the standard deviation is a measurement of how much the investment goes up and down over time—its volatility. A high Sharpe ratio means the investment is paying off relative to its risk.
This ratio is similar to the Sharpe ratio, but instead of dividing by standard deviation, you divide by beta. You may remember that beta shows how much an investment deviates from a market benchmark. In this way, you consider how much the investment outperforms the market.
This measurement is also called Jensen’s measure or simply alpha. It’s a more complex formula, but the upshot is that it compares the investment to the performance of the market as a whole. A positive measurement shows that the investment is outperforming the market, relative to risk, and is a good deal. It’s also used to assess fund managers—a manager who “delivers alpha” is one who consistently outperforms the market and is worth paying for.
How Are Your Investments Performing?
Using these measurements, you can get an idea of your investments’ performance. Are they consistently delivering a positive return on investment? Is any risk you take bringing a proportional reward? You’ll get the most from your time with your financial advisor if you understand these measurements and can discuss them as a savvy investor.To meet the right financial advisor for you, contact us today. We’ll listen to your needs and find a qualified advisor who’s exactly what you’re looking for.