How to Measure the Performance of Your Portfolio?

5 mins read

Every investor is putting their hard-earned money in the market, doing fundamental research, comprehending technical charts, following news, etc. All this is being done to earn returns on their investment and create their wealth. The financial goals may be different for different investors, but the end goal is usually the same for everyone, and that is to make money. One key concern among investors these days is how to track portfolio performance?

This is because portfolio performance or returns are not as simple as computing percentage change of total portfolio amount and amount invested. There are many concepts that investors don’t apply while computing the returns. We will now look at some of the ways you can use to track your portfolio performance. Here it goes:

How are returns from investment (ROI) usually computed?

The returns in your portfolio are usually computed as subtracting the amount you invested from the total portfolio value. This number will then be divided by the total investment amount and multiplied by 100. This is how you were taught to compute returns on any type of investment to track your portfolio performance. It is not theoretically wrong, but it is not complete when it comes to computing returns on your equity portfolio.

Know the risk

The above concept will be complete when you are aware of the risk involved in your investment. Risk-adjusted returns or the risk to reward ratio is something you should calculate before investing. This type of return is also an answer to the question of how to track portfolio performance?

Risk-adjusted returns or real returns is the one where the risk factor is taken into consideration along with the nominal returns.

The mathematical formula to compute the real returns is as follows:

Real Returns: (Absolute Returns/Risk Taken)

A real-life example of this is that investment with 20% returns at lower risk is better than 25% returns with moderate to high risk. If you assign a score to the risk levels from low to high, then you will realize that 20% returns with low risk are better than 25% returns with moderate or high risk.

A testimony to this is that, let’s suppose, the public sector banks in India start offering 10-12% interest rates on fixed deposits, and equity investments will generate 14-16% with high risk and uncertainty. Any investor will prefer 10-12% with no to low risk over risky equity investment offering 14-16%. This is the effect of risk-adjusted returns in investment when you track your portfolio performance.

Let’s now look at some of the ways to compute real returns (risk-adjusted returns) by taking the risk component in the calculation. Here it goes:

Treynor Portfolio Performance

Jack Treynor has come out with a benchmark known as Treynor Ratio, which is known to give the risk-adjusted returns. Treynor ratio is calculated as follows:

Treynor Ratio = (Portfolio Returns – Risk-free Rate) / Portfolio’s Beta}

Beta is defined as the excess of returns of your portfolio over the returns generated by the market indices or the entire market as a whole. A higher Treynor ratio is advantageous as the risk-adjusted returns are better in this case over a lower Treynor ratio.

Sharpe Ratio

Another answer to how to track portfolio performance is by computing the Sharpe ratio to evaluate the returns. This ratio is computed by subtracting the risk-free returns (Government-issued bonds, T-bills, G-Sec, etc.) from the portfolio returns. This difference amount is divided by the standard deviation of the returns from your portfolio. Sharpe ratio simply tells us that the excess returns an investor can make by taking additional risk. A Higher Sharpe ratio goes on to show a better portfolio offering higher returns compared to a portfolio with a lower Sharpe ratio.

Jensen’s Alpha Ratio

Jensen’s alpha or simply alpha ratio is known to compute the quantum of excess returns in a portfolio over and above the expected returns from that portfolio. This is another way to track your portfolio performance to get accurate returns from your investment. This ratio is computed from the Capital Asset Pricing Model (CAPM) to know the difference in returns from your portfolio compared to the returns that you may have earned on a benchmark portfolio by incurring the same level of risk. Jensen’s alpha ratio is calculated by the following formula:

Jensen’s Alpha: {Portfolio Returns – [Risk-free Rate + Portfolio’s Beta * (Returns from Market – Risk-free Rate)]}

This is a very famous ratio used globally, and you can also use it to track your portfolio performance. The higher the value of Jensen’s alpha ratio, the better will be the risk-adjusted returns on your equity portfolio.

These were some of the ways to figure out how to track portfolio performance? However, there are some other simple ways as well to track your investments. They are listed below:

  • Performance vs. Goals:

    You must have started investing since you must be having some financial goals that you want to achieve. You can compare the portfolio returns with the returns needed to achieve your financial goals in the stipulated timeline.

  • Performance vs. Benchmark:

    You can consider an index (Nifty, Sensex, Nifty Bank, Nifty IT, any mutual fund scheme, ETFs, etc.) or a group of stocks as a benchmark to track your portfolio performance. This way, you will get to know whether your portfolio has exceeded the benchmark returns or it did not.

Conclusion:

This is all we had for you in this edition of how to measure the performance of your portfolio. We hope you get a fair understanding of the importance of ‘risk’ while computing the portfolio returns. We also have covered some techniques to track your portfolio performance with risk as a parameter.