As an investor, you should understand how to measure investment portfolio performance. It practically gives you an insight into how well your fund manager is performing in relation to the market benchmark. Considering that the main point of investing is to make money, any fund manager or investor must do basic computations like ROI.
You can easily calculate the return on investment (ROI) by dividing the investment’s cost by its returns or profit for simple investments. This calculation isn’t as professional or accurate as it should be, but it gives the investor an idea of their investment relative to the entire portfolio.
A portfolio consists of several investments. However, to measure and predict a whole portfolio (a situation where you have your resources invested across several asset classes), you need to use a more sophisticated method for your calculations.
Most investors know how to measure their portfolio with a few basic computations. But sometimes, these computational methods are wrong and, at best, give investors the wrong idea of what the figures are or what they’ll be.
According to William F. Sharpe, the 1990 Nobel Prize Winner in Economics and professor at Stanford University:
“The best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative. The latter — often termed a “benchmark” or “normal portfolio” — should be a feasible alternative identified in advance of the period over which performance is measured. Only when this type of measurement is in place can an active manager (or one who hires active managers) know whether he or she is in the minority of those who have beaten viable passive alternatives.”
Sharpe made this suggestion in a piece he wrote in 1991. The idea is as valid today as it was when it was given. In this article, in line with Sharpe’s suggestion, we’ll look at a few essential portfolio measurement metrics. When applied correctly, these metrics give you a good understanding of how well your portfolio is doing or will do in the nearest future. In essence, with these metrics, you can tell whether your investment decisions were wise choices or if they weren’t.
Basic data or information you need to calculate your return on investment
However, before you begin calculating the return on your investment, you’ll need to gather the information or data you need, and this includes:
- The total cost of the investments, including fees such as taxes and commissions
- The average return for all the investments
Also, bear in mind that the return on your investment can be slightly or severely impacted by factors such as shareholders’ decisions, market sentiment, and government policies. Here are some parameters that can be used to measure investment portfolio performance.
Parameters used to measure investment portfolio performance
#1 – Asset Returns
This is the first step. It involves calculating the returns of the assets in a particular portfolio. The assets can be regarded as the individual investments that constitute the entire portfolio. To calculate the asset returns, you’ll need to collate the assets’ historical daily prices and then calculate the geometric returns using the equation below.
Return for each day = Log (Today’s Price/Yesterday’s Price)
However, you can also use data analysis and computational software.
#2 – Asset Expected Mean Returns
Imagine that an investor has bought shares in several companies. The formula given above is used to compute the returns on these shares. To compute the mean on the returns, we use the Asset Expected Mean Returns formula. While there are other ways to do this computation, this method happens to be one of the most common.
The figure you’ll get as the mean gives you a general idea of the entire portfolio’s returns. Remember that the assets make up the portfolio. To calculate the Asset Expected Mean Returns, we use the following formula.
Asset Expected Mean Returns = Sum of returns/Total no. of shares or observations
Note that the result you get from this computation only reflects the figure for one day. To get the mean return on all your assets in a year, you multiply with 252. There are 252 working days in a year. To get the figure for a quarter or a month, multiply by the appropriate number of days.
#3 – Asset Volatility
Asset Volatility is what follows next, after calculating the asset returns. In simple terms, asset volatility tells the fund manager or investor how risky an asset is. This means that assets with high volatility have the highest risk. Statistically, we can calculate each asset’s volatility by calculating each asset return’s standard deviation to the mean asset return.
Standard deviation basically determines the free dispersion of each value around the mean figure. To do this, we first calculate the mean of the values; next, we calculate the variance, which is the mean value of the square of the difference between each value and the mean. Finally, we calculate the square root of the variance. This gives you the standard deviation of asset volatility.
#4 – Portfolio Expected Return
At this point, you can compute the expected return of the portfolio. Since the portfolio holds different assets, expect that each asset contributes a certain weight to the portfolio. Each asset has a corresponding weight assigned to it. For instance, asset A has 20%, B holds 40%, and C holds another 40%. The Portfolio Expected Return can be calculated from the Asset Expected Return calculated above. The formula below can give the value:
Portfolio Expected return = Sum (Weight X Asset Expected Return) of each asset
#5 – Portfolio Volatility
The portfolio volatility is the portfolio’s total risk and is calculated in like manner as the asset volatility. However, in this case, we calculate the standard deviation of the returns on each stock investment and the covariance between each stock pair.
Some other parameters or metrics go into calculating your investment portfolio performance. However, with the aid of data analytics tools, most of these computations can provide fewer hassles and be more accurate.
Tycoono Media Inc. and its affiliates do not provide tax, legal, financial or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, financial or accounting advice. You should consult your own tax, legal, financial and accounting advisors before engaging in any transaction. Please refer to our disclaimer for more information.