An investment portfolio and strategy are key components of a comprehensive financial plan for retirement and long-term economic prosperity. The goal of any investment portfolio should be to generate profit over a particular period; however, the success of a portfolio is measured by several different metrics and benchmarks.
For instance, one fund might produce decent returns over a year, but to accurately assess performance you must be aware of factors such as risk, market volatility, and how those returns measure up against the broader markets. The following are seven key metrics used to assess the success of an investment fund.
1. Standard Deviation
Expressed as a percentage, standard deviation refers to the degree to which a set of data or individual value varies from the distribution mean. It is generally used in the finance sector to highlight the historical volatility of a particular investment.
A stock with an inconsistent performance record, for instance, will have a higher standard deviation percentage compared to a relatively stable blue-chip stock. It can also be used to indicate the level of risk the portfolio manager is willing to accept; a lower standard deviation generally points to a low-risk investment strategy, whereas a higher standard deviation might suggest the manager is comfortable making aggressive bets to generate above-average returns.
To calculate the standard deviation, you must first know the mean value of all points in a particular data set. This is generated by adding all points and dividing that figure by the total number of points. From there, the variance of each point, which is generated by subtracting the mean from its given value, is squared and added together. This figure is once again divided by the total number of data points minus one. The standard deviation is the square root of the resulting figure.
2. Sharpe Ratio
Once you know the standard deviation, you can use the Sharpe ratio to assess the performance of an investment fund. This metric, often referred to as the reward-to-variability ratio, is calculated by subtracting the risk-free rate from the portfolio’s expected rate of return, with the resulting figure divided by the portfolio standard deviation.
Created by Nobel laureate William F. Sharpe, the Sharpe ratio is arguably the most prevalent portfolio management metric, highlighting the investor’s performance against positions of high risk. The higher the Sharpe ratio, the better.
3. Sortino Ratio
The Sortino ratio is similar to the Sharpe ratio in that it takes risk into account, but it differs in the extent of risk. Whereas the Sharpe ratio accounts for overall risk, the Sortino ratio is a risk-adjusted measure that helps investors evaluate returns for a specific level of downside risk. Similar to the Sharpe ratio, a higher ratio is preferred.
The Sortino ratio is calculated by subtracting the target return from the expected return and dividing the result by the downside standard deviation, which concerns oscillating returns below a certain benchmark.
In addition to overall returns and success against various risk levels, investors want to know how volatile investment funds are relative to the market over extended periods. Beta is a benchmark of that volatility as it measures a particular stock or fund’s sensitivity to swings in the market. Mostly used in the capital asset pricing model (CAPM), it can help investors estimate expected returns of assets while taking into account the cost of capital and risk. A Beta value of 1.0 indicates that the price activity of a stock maintains a strong correlation to the market. Values greater than 1 indicate more volatile prices relative to the market, while values less than 1 indicate more stable prices.
Alpha is a measurement of the stock or fund’s performance against its relevant benchmark index price and, like Beta, is primarily used in CAPMs. If a CAPM analysis determines that a fund should have generated a 5 percent return based on risk and various market factors, but the fund instead earned only a 2 percent return, this would result in a disappointing alpha of -3 percent. Zero is viewed as the baseline for success regarding the alpha metric, and any number above that indicates a high level of investor performance.
R-squared provides investors with insight into the reasoning behind significant price movements of a stock or fund. More specifically, it is a percentage of how much of this movement can be attributed to volatility in the broader market. R-squared percentages between 85 and 100 indicate the portfolio’s performance is heavily tied to the performance of the index. Conversely, a fund with a low R-squared (usually around 70 percent or less) indicates the portfolio isn’t generally aligned with the movements of the index.
7. Maximum Draw-Down
Maximum draw-down presents investors with a worst-case scenario by measuring the maximum amount an investment portfolio lost during a certain timeframe. While this does provide valuable insight into portfolio performance, it is viewed as an incomplete metric as it doesn’t provide necessary contexts such as draw-down frequency and the length of time it took to recover losses.