Evaluating Portfolio Performance – Part 1

This Article is Part 1 of a 2-Part Series on Evaluating Your Portfolio Performance

Performance Anxiety?  It’s okay.  It’s normal.  It happens to most people at some point in their lives.  Your neighbor is bragging, your spouse is upset or it seems like the entire world is up and you’re just not quite…up as much?  Yet investing (investing, of course) is unlike most worries where you can ease your anxiety by taking action; doing so with investing often leads to sub-optimal outcomes, particularly in the long run.  And if you’re going to be investing for the long-term – the only time frame in which it makes sense to invest in the stock market as any fee-only investment advisor will tell you – doesn’t it make sense to have proper expectations?  Shouldn’t you have a pretty good idea of how to evaluate your investment performance?  This article will help you understand the risk/reward trade-offs inherent to investing, and put your portfolio performance into context so you can have a better, more informed and smoother investment experience.

Portfolio Volatility and Performance Expectations

Investment risk is commonly defined as how much your investments bounce around their historic averages, more commonly referred to as its volatility.  Volatility is a term used frequently in finance and for most stocks, mutual funds, bonds, ETFs and securities in general, one way to measure the volatility of an investment is by its standard deviation.  Simply put, the standard deviation is how much we can expect a given security’s performance – the pluses and minuses –  to bounce around the average return for that investment.  As you may remember from 9th or 10th grade, assuming a normal distribution (the bell curve) of returns, 68% of observations can be seen within +-1 standard deviation, 95% within +-2, and 99.7% of within plus or minus 3 standard deviations.

Using generously-rounded historical numbers for the S&P 500, assume the index has returned 10% average over the past 50 years with a standard deviation of 15%.  We can therefore assume that 95% of the time (plus or minus 2 standard deviations) it has returned  between -20% and 40%.  Furthermore we can then (somewhat reluctantly and always with the caveat regarding past and future returns) extrapolate that it may in the future return something similar.  Of course, this doesn’t mean you won’t see a year with -30% or +50%, but it would be abnormal.

Everything that moves therefore has a standard deviation, and something that moves around its historical average (mean) a little, like a treasury bond, will have a lower standard deviation than a stock.  Furthermore you should expect an emerging market stock to bounce around more than a developed-market international or domestic stock.  This is why diversification is so important!  The idea is not to eliminate fluctuations in your portfolio, but to allocate funds, according to your risk tolerance, across asset classes that may behave differently in different market conditions but over time, reduce the volatility of your entire portfolio.  Sure, one part of your portfolio may be down while another is up, but you don’t want everything in your portfolio moving in the same direction at one time.  What you should be aiming for is a smoother long-term investing experience, with your portfolio as a whole up over time.

Risk-Adjusted Performance…Introducing the Sharpe Ratio

Financial planning and portfolio management clients of the firm are likely familiar with my love of the Sharpe ratio, named after William Sharpe who is credited with developing it in the late 1960s.  While there are numerous methods of evaluating investment and portfolio performance on a risk-adjusted basis, none is as simple or profound as the Sharpe ratio.  Before getting to the (simple) formula, let’s look at an example: Stock A has returned a relatively low six percent per year over the past 5 years.  Stock B has returned 10% per year over the same period.  From a strictly performance standpoint, an investor would choose to invest in stock B.  Yet the savvy investor (perhaps you, dear reader) may ask about the volatility as the volatility helps to put the entire investing experience into better context.  If stock A had a standard deviation of 4 (meaning it didn’t move around very much at all) and stock B was a small biotech stock with a standard deviation of 32, it helps to have a measure to evaluate these two investments against each other.  Enter the Sharpe Ratio.

The Sharpe Ratio simply takes the investment’s return, subtracts out the risk free rate, generally assumed to be short-term US government debt (T-Bills), and divides that by the standard deviation of the investment.  Ignoring the fact that US Government debt may not be a great proxy for risk-free investments, it’s really that simple.  In this case, assuming T-Bills are paying 2%, Stock A has a Sharpe ratio of 1 ((6-2)/4).  Stock B has a Sharpe ratio of just .25 ((10-2)/32).  The higher the Sharpe ratio, more return per unit of risk.

Getting Compensated For the Risk in Your Portfolio – Putting it Together

Most people are familiar with the risk-reward trade off that occurs with investing; that over time, you cannot and will not have performance that is inconsistent with the risk metrics of the given investment.  If your portfolio is up 20%, it’s because there was sufficient movement within the underlying investments to produce such gains.  In this case, the movement was up.  But almost by definition the same investments could have sold off by similar amounts (though not all investments have a 1:1 positive to negative potential).

I frequently tell clients that they are (read: should be) compensated for the risks within their portfolio; no more and no less, and give them a one-or-two sentence explanation about risk-adjusted returns; after all, lengthy explanations are for blog posts and curing insomnia.  Getting compensated for the risks within your portfolio is my way of addressing a number of questions and comments from clients, including such classics as “why is my performance X when the market performance is Y,” and “my portfolio is down since we invested”.  Unless you’re 100% in cash, a portfolio always has the potential for loss.  In fact, however, investors who remain in cash for significant periods of time will experience one of the few near-certainties of investing; that over time you’ll lose money to inflation.  If you want to earn gains within your portfolio, it requires investing in securities that have the potential to go up, and those same securities, generally speaking, have the potential to go down.

Stay Tuned for Part 2… to be published early March, 2020