The success of the portfolio cannot be determined based on its returns. There have been ways to evaluate the performance of a collection in the past. None have the design that considers both risks and returns simultaneously. Ever since 1960s investors have either found the risk or the basis has been the returns. There are specific ways one can think to delve deeper and analyze their portfolio’s performance and get a clear and more appropriate insight.
The first person to consider risk as a basis was Treynor. He provided the investors with a much more practical approach. Regardless or personal risk preferences, providing a general measure of performance was the main aim of Treynor. According to him, there are two types of risks- The risk associated with the stock market and the risk associated with individual securities. He introduced the idea of a security market line. It is how it looks:
Treynor Measure= (PR-RFR)/beta, where,
PR stands for portfolio return,
RFR stands for the risk-free rate
The ratio is also termed as a reward to volatility ratio.
The numerator denotes risk premium, whereas the denominator indicates the portfolio risk. A higher value always means a better position.
Sharpe ration is quite close to the Treynor Measure with only a slight deviation. It is how it looks
Sharpe Ratio= (PR-RFR)/SD where,
PR denotes portfolio return
RFR denotes risk-free-return
SD indicates standard deviation.
The sole difference between Treynor Measure and Sharpe Ratio is that beta is replaced with the standard deviation in this case. The basis, in this case, is the rate of return and diversification. It is considered to be more accurate when compared to Treynor Measure.
Jensen measure calculates the surplus return over the anticipated return. This kind of performance is termed as Alpha. It is how it looks like:
Jenson’s Alpha= PR-CAPM
Where PR denotes portfolio return
CAPM indicates risk-free rate+ beta (return of risk-free market rate of return.
The higher the output, the better is the portfolio performance, in this case. The risk for securities and the rate of return differs from time to time. This kind of ratio works best on certain types of investments, such as mutual funds.
The measurement and evaluation of a portfolio performance tell you how your decision related to your investment was. Was it fruitful, or was it not up to the mark? The estimation is essential to be able to proceed further if your decision paid off or improve in case it didn’t. However, it is crucial to note that measuring the portfolio results is only a part of the larger picture. It cannot ascertain the entire investment scenario. The only drawback of these methods is that due to incomplete or half knowledge, one could end up taking clouded financial decisions, which is detrimental to the investor in the long run. Thus, it is essential for the investor to realize that this may be a key factor but not the only factor to rely on.
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