In life, a lot of value is given to performance. In sports, good performance merits more playing time. On the job, good performance can be rewarded with promotions, raises, and formal and informal leadership. How well someone or something performs can be very important.
No matter the scenario, there are many different ways of measuring performance. In sports, it might be statistics. At work, it may be a formal performance review or what was added to the bottom line. When it comes to investing and our portfolio, how do we measure that performance?
Many assume a portfolio will do what it is “supposed” to do, and don’t measure their performance at all. It is wise to keep an eye on your portfolio, as performance left unchecked can mean a lot of lost growth.
We have outlined some measures of performance that we think are important. The concepts might be rather technical but we will do our best to keep it simple and straightforward.
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We have mentioned this term several times in the past. Upside and downside capture compares a portfolio, fund, or specific security against a benchmark. The benchmark is generally an index (in Canada usually the S&P/TSX composite), but could also be the market as a whole.
Upside and downside capture tell you how much of the market gains and losses your portfolio, fund, or specific security participated in. This is very easy to track for most ETF’s as the general goal is to replicate an index exactly or by sampling. For more information on the topic read our blog post entitled Upside/Downside Capture in your Investment Portfolio.
We won’t explain how Beta is calculated, as that is rather technical and not crucial to understanding it’s significance. What is more important is the concept behind it and what it measures.
Beta is a calculation that measures the volatility or systematic risk of a security or portfolio against a benchmark or the market as a whole. Beta is used in other calculations as well to find things like expected return.
If a stock or portfolio has a beta of more than 1.00, it means it is more volatile than the benchmark or market. For example, if the beta is 1.10, the measured stock is 10% more volatile than the benchmark. This means that the stock or portfolio would be expected to increase or decrease by 10% more than the benchmark or market.
Stocks and portfolios can also have a negative beta (i.e., -1.00). This would mean that it is inversely correlated to the benchmark or market. “Put Options” and “Inverse ETF’s” are designed to have a negative beta.
As with Beta, we will not be explaining the actual calculation here. Alpha is used to measure performance, and is often referred to as the “active return”, or extra value added.
Alpha is the return that the security or portfolio generated above the return of the benchmark or market.
Alpha is usually quoted as a single number (i.e., -2, +4) but refers to the percentage the portfolio or security performed compared to the benchmark (i.e., -2 = 2% worse, +4 = 4% better). Alpha is often used together with beta when analyzing the performance of a portfolio.
The alpha of an overall stock portfolio is often seen as the value that the investment advisor provides. The higher the alpha, the better the advisor did at out-performing the benchmark. If your portfolio has a negative alpha, it has under performed the benchmark, and your advisor did not do a great job.
Sharpe ratio is a measure of return compared to risk. Another term often associated with Sharpe Ratio is “Risk-Adjusted Rate of Return”. The ratio describes the average return earned above the risk-free rate of return per unit of volatility.
When investing, you want to get the best return you can for the amount of risk that is being assumed. If investment “A” is super risky with mediocre benefits, investors are less likely to participate. If Investment “B” is less risky but has practically the same benefits, more investors are likely to participate.
In essence, the Sharpe Ratio lets us know if the reward that we get in the future is worth the risk we are taking now.
Although these terms are technical they are important to comprehend. We would encourage you to ask your advisor(s) about the performance of your portfolio in regards to these concepts.
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Disclaimer: This Forbes Wealth Blog is for informational purposes only and does not constitute financial, legal, or tax advice of any kind. Please consult your legal, accounting, tax, investment, banking, and life insurance professionals to get precise advice relating to your particular situation before acting upon any strategy.