Measuring the performance of investments is one of the most important things for investors because it allows them to see if their investment strategy is working to achieve the returns they want. Investors use metrics and tools to inform their investment decision-making and make sure their portfolios are optimized.
This article will discuss methods of evaluating your investment performance and adjusting your strategies accordingly.
1. Total Return – The Best All-Around Investment Performance Metric
The total return of an investment is one of the best metrics to measure the performance of your investments. This metric includes both the gain or loss in value of your investment (capital gains/losses), plus any income you receive from the investment (dividend payments, interest etc.) This allows you to get a true picture of how well the investment has done during the evaluation period.
How to Calculate Your Total Return:
Capital Gains – Difference between what you paid for the investment and what you sold the investment for.
Income – Any dividend payments, interest or any other type of income received from the investment.
Reinvestments – Reinvested dividend payments or interest are included in the total return calculation as well.
Your total return provides you with a way to compare the overall performance of the investment over a specific period, and not just its price fluctuation.
2. Risk-Adjusted Return – Getting Your Reward While Controlling Your Risk
Risk-adjusted return measures the return on an investment, in terms of the amount of risk that was taken to earn that return. It is a way for investors to assess whether the potential reward of an investment is worth taking on the associated risk. Some of the common risk-adjusted return metrics are the Sharpe Ratio and the Sortino Ratio.
Some Key Risk-Adjusted Return Metrics:
Sharpe Ratio – Measures the excess return earned above the risk-free rate (i.e. inflation), per unit of volatility. A higher ratio indicates a greater risk-adjusted return.
Sortino Ratio – Similar to the Sharpe Ratio but only considers downside volatility; providing a clearer view of the risk.
Alpha – Compares the actual return of an investment to its expected return based upon a benchmark index, taking into account the level of risk.
Using risk-adjusted return metrics allows you to understand whether your portfolio is appropriately optimized for risk and return.
3. Benchmark Comparisons – How Does Your Investment Perform Compared To The Market?
Benchmarking compares the performance of an investment to a particular market index or benchmark. By comparing the return of an investment to that of a benchmark index, you can see how your investment is doing relative to the larger market.
Here Is A Step-by-Step Guide For Benchmarking:
Select an Appropriate Benchmark Index – Choose a benchmark index which is comparable to the investment’s asset class (Example: S&P 500 for U.S. Equities).
Compare Returns – Compare the returns of the investment to the returns of the benchmark index, over the same evaluation period.
Account For Risk – Consider the risk profiles of both the investment and the benchmark when making the comparison.
Comparing the return of an investment to a benchmark index provides insight into whether your investment is performing better than or worse than the average investor.
4. Time-Weighted Return (TWR): Accounting For Cash Flow Timing And Amounts.
Time-weighted return (TWR) is a measurement method that evaluates the performance of an investment portfolio while including the timing and magnitude of all cash flows (inflows/outflows) into the return calculation. The TWR method is especially useful when evaluating the performance of a portfolio where the manager is a third party, since TWR eliminates the effect of any outside cash flow.
How TWR Works:
Include Cash Inflows & Outflows – Cash inflows and outflows are included in the return calculation at the point they occurred.
Evaluate Portfolio Manager Performance – TWR enables you to evaluate the performance of the portfolio manager, independent of any contributions made to the portfolio by individual investments.
The TWR method is very useful for evaluating the performance of professional money managers and funds.
Conclusion
To measure the performance of your investments, you need to be able to measure return, risk, and how your investment performs compared to a specific market benchmark. Using total return, risk-adjusted return, benchmark comparisons, and time-weighted return allow you to have a comprehensive understanding of your investments’ performance. These tools enable you to make informed decisions about your investments and continually modify your investment strategy to optimize the performance of your investment portfolio.
