Measuring your success in managing your portfolio
Beginner Stock Market Investing, Stock Market Investing Advice
How your portfolio performs in overall terms is the only way to measure your success as a portfolio manager. Just as you would expect to measure the success of an outside portfolio manager if you give him your portfolio to handle, it is only right that you should use the same benchmarks to assess your portfolio if you manage it yourself. The important point is that you should remember is that just using the total return on your portfolio investment is not sufficient to do the job.
For example, your portfolio has delivered a return of 2% per annum which make seem inadequate but is really an excellent return if the market overall has delivered a return of only 1% during the same period. On the other hand, in the same circumstances, if your portfolio is high risk (comprised of penny stocks for instance) the extra return of 1% is not sufficient compensation for the risk. Your return therefore needs to be adjusted for risk in order to provide an objective basis of measurement. Many of the ratios used for this purpose consists of establishing a benchmark rate (often the risk-free return on government securities) and then comparing the risk-adjusted return to the benchmark.
Reward to variability ratio. This is popularly known as the Sharpe ratio and is one of the most common measures of portfolio performance management. The return for the portfolio is measured against a benchmark (in this case the risk-free return on say government securities and bonds) and the excess over this benchmark represents the return over that benchmark. Because higher risk should produce higher returns, the higher the Sharpe ratio, the better the risk-adjusted performance.
Safety first ratio. Also known as the Roy’s ratio, this ratio is much like the Sharpe ratio but there is one important difference. Instead of using the risk-free rate as the benchmark, this ratio measures the actual performance of the portfolio against your expected target rate of return. The target rate of return can be determined in a number of ways such as the income that you require to maintain your lifestyle. In this case, if you require $50,000 per year, a portfolio of $1 million should provide you with a return of 5% at least. You could always choose to use another target rate of return such as the Standard and Poor’s 500 index. The safety element comes into the picture because you have to achieve your minimum target return.
The information ratio. This is considered to be a more complicated ratio but a better measure of your ability to pick stocks. Especially if you follow an active investment strategy rather than a passive investment one, this is the ratio for you. Even if you only invest in blue-chip stocks, you should be able to capitalize on temporary market miswriting and the return that you achieve over your benchmark is called an active return. The ratio uses the standard deviation of active returns as the way to measure risk.
As you will see, these and similar measures that are used all have the same objective. They all attempts to measure some kind of excess over the benchmark and then adjust this return for every unit of risk. Generally speaking, it would be fair to say that the higher the ratio, the more superior to the risk adjusted performance.
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