February 17, 2023
If you are relatively new to the world of individual investing, you measure the success of your portfolio simply by looking at returns without consider the risks involved in achieving them. So if returns isn’t enough, what should retail shareholders look for when measuring the success of their portfolios?
Returns and risks are the two most important factors in determining the health of a portfolio, but they are not the only measures. Returns can certainly signal performance, but without risk measures like standard deviation, it creates a cloudy picture, at best. It is important to measure any performance on a benchmark, which could be the S&P 500 or other stable asset.
While you can certainly spend too much time monitoring your portfolio, it is important to watch and keep track of its performance. Most individual investors look at their portfolios quarterly.
The consensus of several financial education websites suggests six important performance measures: Return vs. Benchmark; Standard Deviation; Beta; R-Squared; Sharpe Ratio; and Sortino Ratio. Seeking Alpha describes them as:
Return vs. Benchmark
This is where retail shareholders should start. Performance can be monitored for each investment or for the entire portfolio. For example, in addition to using the S&P 500 index for stock holdings and the Barclays Aggregate for bonds, an investor with a moderate allocation of 60% stocks and 40% bonds may choose to use a balanced index fund with a similar allocation, such as Vanguard Balanced Index (VBIAX). Alternatively, according to Seeking Alpha, the investor can take a weighted average of the returns of the indices, where the weights equal the asset allocation of their portfolio.
Standard deviation is the statistical measure of market volatility, measuring how widely prices are dispersed from the average price, according to Fidelity. If prices trade in a narrow trading range, the standard deviation will return a low value that indicates low volatility. For example, a higher standard deviation indicates a greater price variation, or higher volatility, from average performance.
Beta is another way of measuring a stock’s volatility compared with the overall market’s volatility. The market as a whole has a beta of 1. Using that baseline, retail investors can measure volatility. Simply put, stocks with a value greater than one are more volatile than the market. Stocks with a beta of less than 1 will still move up and down with the market, but not as wildly as those with a value of more than 1. Stocks can have a negative beta, though it is unusual. In that case, the stocks move in the opposite direction of the market.
R-squared measures the relationship between a portfolio and its benchmark index, expressed as a percentage from 1 to 100. R-squared is not a measure of the performance of a portfolio. Instead, it measures the correlation of the portfolio's returns to the benchmark's returns. If you want a portfolio that moves like the benchmark, you'd want a portfolio with a high R-squared. An R-squared of 100 indicates that all movements of a portfolio can be explained by movements in the benchmark. For example, an index fund that tracks the S&P 500 invests in the same stocks in the same proportions as the index; therefore, its R-squared relative to the S&P 500 Index is very close to 100.
The Sharpe Ratio is calculated using standard deviation and excess return to determine reward per unit of risk. The higher the Sharpe Ratio, the better the portfolio’s historical risk-adjusted performance. The Sharpe Ratio looks at risk-adjusted return, the level of volatility an investor is required to assume to achieve a return higher than a risk-free asset. A good Sharpe ratio is one higher than 1.5.
The Sortino ratio is a risk-adjustment metric used to determine the additional return for each unit of downside risk. It is computed by first finding the difference between an investment’s average return rate and the risk-free rate. The result is then divided by the standard deviation of negative returns. Ideally, a high Sortino ratio is preferred, as it indicates that an investor will earn a higher return for each unit of a downside risk.
Keeping an eye on the performance of your portfolio is important work for an individual investor, but it is also important to not get bogged down in statistics. Be watchful for stocks that are moving differently than the benchmarks and adjust when needed.
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