Rarely anymore does investing get seen as a privilege of the rich. That gets proven by a recent Gallup survey that shows that over one hundred and fifty million Americans now invest in stocks. While this percentage is still below the ones noted before the housing market crash of 2008, it is still the highest in thirteen years. Hence, US residents are again waking up to the fact that building wealth is a long-term process available to most individuals with regular income. And to successfully trade securities, one must show long-haul focus and discipline. For that to happen, people need to build varied investment portfolios, implementing sound trading strategies that have track records of yielding double-digit annual returns.

Per research from Personal Capital, the average age when people start investing in the US is 33, with Saxo claiming that Gen Z members prefer financial stocks, followed by real estate and technology assets. Naturally, investment styles differ, but a core foundational principle for most is diversification. Like any sphere, the investing one also has its language, and the primary questions everyone must ask when building their portfolio is how much they want to spend monthly, how much help they require when investing, what are their goals, their risk profile, and what assets can best lead them to hit projected milestones.

It is too essential to recognize that chosen asset allocation can get out of whack sometimes, and a degree of rebalancing may be on the docket to restore an investment portfolio to its original makeup. To properly assess when this is mandatory, investors must know to track the performance of their securities and then make adjustments when necessary, selecting which underweighted ones to purchase with the proceeds from off-loading their overweight assets. Ascertaining one’s financial situation and aims is the first step in constructing a portfolio. Then follows the monitoring of one’s investments. To help with that process, here are five methods of measuring a portfolio’s performance.

Sharpe Ratio

William Forsyth Sharpe is a University of California Ph.D. who taught Finance at Stanford University. A 1990 Nobel Memorial Prize winner in the area of Economic Sciences. He gets touted as one of the financial masterminds of the 20th century, renowned for creating the Sharpe ratio for risk-adjusted investment analysis. It is a reward-to-variability index developed in the mid-1960s, measuring the performance of an investment (a portfolio or security) stacked up to a risk-free asset after adjusting the risk factor. For the past three decades, it has become one of the most preferred risk/return measures in finance, with a sizable deal of its establishment getting credited to its simplicity.

Many financial experts would describe this ratio in rudimentary terms by stating that it compares the return on investment with its risk. Mathematically, the formula can get rudimentary explained in its simplest form as the return of the portfolio minus the risk-free rate divided by the standard deviation of the portfolio’s excess return. The latter gets derived from the variability of returns for a set of intervals summing up to the considered total performance sample. Essentially, the Sharpe ratio compares a portfolio’s projected or historical returns relative to a benchmark with the expected or historical variability of such returns. It mainly gets used to evaluate a portfolio’s risk-adjusted performance.

A vital issue many have with investment managers using it is that it can get manipulated by elongating the return measurement intervals. That produces a lower estimate of volatility, boosting an apparent risk-adjusted returns history.

Sortino Ratio

In truth, the Sortino ratio is nothing more than a variation or a modification of the Sharpe formula. Instead of using the total standard deviation of portfolio returns, it utilizes the asset’s standard deviation of negative portfolio returns (downside deviation) to differentiate harmful volatility from the overall one. It ignores the above-average returns in exchange for solely focusing on the downside deviation, believing it to be a far better proxy for the risk of a portfolio fund. Many think by doing this, a better view of a portfolio’s risk-adjusted performance gets provided.

It is named after Frank A. Sortino, the Director of the Pension Research Institute and former San Francisco State University finance professor. What Sortino’s ratio does is it looks at an asset or portfolio’s return and then minimizes the risk-free rate. Then, it splits that sum by the downside deviation of the asset. So, if the expected returns are 20%, the risk-free rate is 10%, and the downside deviation is 4%. The ratio would be 2.5. Without question, this is a handy method for portfolio managers, investors, and analysts to assess an investment’s return for a given degree of bad risk. Many mutual funds implement this statistical tool, noting that they do so because it tends to supply fairly accurate reads.

Treynor Measure

Most financial managers have nicknamed the Treynor ratio the reward-to-volatility one. Again, people will say that this is an iteration of the Sharpe, and they are not wrong because it is a ranking criterion only. It does not quantify the value added to active portfolio management. The goal of this metric for performance is to show how much extra returns got generated for each unit of risk incurred by a group of investments. The danger/risk referred to here is the systematic one measured by a portfolio’s beta. For the non-investment-savvy readers, a Beta is a measure of a portfolio’s systematic risk compared to an entire market, often the S&P 500. As a rule of thumb, stocks that boast betas of more than 1.0 get viewed as more volatile than the S&P 500. Beta also gets implemented in CAPM, or the capital asset pricing model that describes the link between the expected return for assets and systematic risk. CAPM is considered by most as an instrument for pricing risky securities.

The formula for the Treynor Ratio is subtracting the risk-free rate from the portfolio return and then dividing this by the beta of the portfolio. The goal here is to try to gauge how successful an investment will be in terms of yielding compensation to investors for taking on the noted risk.

The focal downside of the formula is its backward-looking outlook, as investments will probably behave differently than how they did so before. The success of applying this principle heavily relies on implementing quality benchmarks to measure beta.

Its inventor is American economist Jack Lawrence Treynor, a mentor of Fischer Black, one of the creators of the Black–Scholes model, and a protégé of the 1985 Nobel Memorial Prize in Economics winner, Franco Modigliani.

Benchmark Returns with Indexes

Being able to continuously measure the performance of multiple investments at any given time delivers a substantial advantage in the process of trading securities. Thankfully, that can be done nowadays using various software that can create different kinds of charts and tables using automatically updated data in seconds.

The terms indexes and benchmarks are often utilized interchangeably by both laypeople and casual investors. Yet, they are unique ones that delineate different things. An index is a statistical tool designed to gauge market performance over time. For example, the DJIA, or Dow Jones Industrial Average, is a securities index created to assert the accomplishment of stocks representing a significant chunk of the US economy. While a benchmark, by definition, serves as a standard, a reference point by which other things get judged.

With a portfolio management app, users can set up benchmark columns to track a stock’s performance vs. its index. Note, by default, most investing software will use the S&P 500 index as a comparison benchmark, but that can get modified in a setting’s window.

Also, today, investors have multiple benchmarks to choose from in apps. Some of these are fixed-income and traditional equality benchmarks. Plus, users have more exotic ones on hand, invented for real estate, hedge funds, derivatives, and other types of investments. But explaining these is outside the scope of this article.

In general, most investors look at broad historical indexes as benchmarks when evaluating how their trades are doing. Those investors that own stocks frequently, if not religiously, check out the Nasdaq 100, the mentioned DJIA, and the S&P 500 to see – where the market is at. That is simple, even without an app, because these indexes get tracked by worldwide financial media outlets. Active management investors must ensure that they are implementing proper benchmarks that their returns get compared to at distinct intervals. And sadly, research shows that most actively traded portfolios fail to beat benchmarked indices after factoring in taxes and fees. Thus, that is the reason so many people claim that it is wiser to take the passive indexed route to invest practices.

Jensen Measure

Michael Cole Jensen is an Alma mater at the Macalester College University of Chicago and has worked in economics for sixty years, teaching at Harvard University and the University of Rochester during his illustrated career in American economics. In academic circles, he gets credited for playing an essential role in corporate governance, stock option policies, and capital asset pricing models. Though, by far, his most massive contribution to finance gets considered the so-called Jensen’s alpha/measure.

What is Jensen’s alpha? It is another risk-adjusted performance measure, an ex-post alpha that gets utilized to figure out the abnormal return of a portfolio/security over the theoretical expected return. The theoretical return most commonly gets predicted by the capital asset pricing model, but other market models can be used that incorporate statistical methods to predict the appropriate risk-adjusted return of an asset. As discussed above, the capital asset pricing model, or CAPM for short, uses beta as a multiplier. So, Jensen’s measure quantifies the excess returns accrued by a portfolio above the returns projected by the capital asset pricing model.

The formula for Jensen’s alpha is taking the portfolio return and taking away from it the total of the sum of the risk-free rate when one adds to it the beta multiplied by the total of the expected market return with the risk-free rate subtracted from it. That may be a bit complicated for some to grasp in text form and require further exploration. But, the value of the alpha can be positive – showing outperformance, negative – displaying underperformance, and zero – neutral performance.

Critics of Jensen’s measure generally state that the disadvantage of this approach is that it does not take into account the portfolio’s volatility, only its expected return. And it misses out on attributes like skewness and kurtosis, pointing to Eugene Fama’s efficient market hypothesis (EMH) as something fans of Jensen’s measure should look into and analyze.

Parting Thought

These and other tools can deliver pivotal information to investors regarding how effectively their money is working for them. Remember, portfolio performance measures should have a determining part in future investment decisions, but they only show part of the story. Just because stocks are not doing well at the moment or for the past several months, that does not mean they have little long-term value. So, there is something to be said about having long-haul perspectives and beliefs in specific companies, ones that may be on the verge of innovating or those whose accurate value will only get recognized down the line. Still, without adequately assessing risk-adjusted returns, no one can view the entire investment big picture. Not having such sight can indirectly lead to misadvised decisions that can have dramatic consequences. Therefore, it is smart to measure performance periodically.

How to Measure a Portfolio’s Performance

Rarely anymore does investing get seen as a privilege of the rich. That gets proven by a recent Gallup survey that shows that over one hundred and fifty million Americans now invest in stocks. While this percentage is still below the ones noted before the housing market crash of 2008, it is still the highest in thirteen years. Hence, US residents are again waking up to the fact that building wealth is a long-term process available to most individuals with regular income. And to successfully trade securities, one must show long-haul focus and discipline. For that to happen, people need to build varied investment portfolios, implementing sound trading strategies that have track records of yielding double-digit annual returns.

Per research from Personal Capital, the average age when people start investing in the US is 33, with Saxo claiming that Gen Z members prefer financial stocks, followed by real estate and technology assets. Naturally, investment styles differ, but a core foundational principle for most is diversification. Like any sphere, the investing one also has its language, and the primary questions everyone must ask when building their portfolio is how much they want to spend monthly, how much help they require when investing, what are their goals, their risk profile, and what assets can best lead them to hit projected milestones.

It is too essential to recognize that chosen asset allocation can get out of whack sometimes, and a degree of rebalancing may be on the docket to restore an investment portfolio to its original makeup. To properly assess when this is mandatory, investors must know to track the performance of their securities and then make adjustments when necessary, selecting which underweighted ones to purchase with the proceeds from off-loading their overweight assets. Ascertaining one’s financial situation and aims is the first step in constructing a portfolio. Then follows the monitoring of one’s investments. To help with that process, here are five methods of measuring a portfolio’s performance.

Sharpe Ratio

William Forsyth Sharpe is a University of California Ph.D. who taught Finance at Stanford University. A 1990 Nobel Memorial Prize winner in the area of Economic Sciences. He gets touted as one of the financial masterminds of the 20th century, renowned for creating the Sharpe ratio for risk-adjusted investment analysis. It is a reward-to-variability index developed in the mid-1960s, measuring the performance of an investment (a portfolio or security) stacked up to a risk-free asset after adjusting the risk factor. For the past three decades, it has become one of the most preferred risk/return measures in finance, with a sizable deal of its establishment getting credited to its simplicity.

Many financial experts would describe this ratio in rudimentary terms by stating that it compares the return on investment with its risk. Mathematically, the formula can get rudimentary explained in its simplest form as the return of the portfolio minus the risk-free rate divided by the standard deviation of the portfolio’s excess return. The latter gets derived from the variability of returns for a set of intervals summing up to the considered total performance sample. Essentially, the Sharpe ratio compares a portfolio’s projected or historical returns relative to a benchmark with the expected or historical variability of such returns. It mainly gets used to evaluate a portfolio’s risk-adjusted performance.

A vital issue many have with investment managers using it is that it can get manipulated by elongating the return measurement intervals. That produces a lower estimate of volatility, boosting an apparent risk-adjusted returns history.

Sortino Ratio

In truth, the Sortino ratio is nothing more than a variation or a modification of the Sharpe formula. Instead of using the total standard deviation of portfolio returns, it utilizes the asset’s standard deviation of negative portfolio returns (downside deviation) to differentiate harmful volatility from the overall one. It ignores the above-average returns in exchange for solely focusing on the downside deviation, believing it to be a far better proxy for the risk of a portfolio fund. Many think by doing this, a better view of a portfolio’s risk-adjusted performance gets provided.

It is named after Frank A. Sortino, the Director of the Pension Research Institute and former San Francisco State University finance professor. What Sortino’s ratio does is it looks at an asset or portfolio’s return and then minimizes the risk-free rate. Then, it splits that sum by the downside deviation of the asset. So, if the expected returns are 20%, the risk-free rate is 10%, and the downside deviation is 4%. The ratio would be 2.5. Without question, this is a handy method for portfolio managers, investors, and analysts to assess an investment’s return for a given degree of bad risk. Many mutual funds implement this statistical tool, noting that they do so because it tends to supply fairly accurate reads.

Treynor Measure

Most financial managers have nicknamed the Treynor ratio the reward-to-volatility one. Again, people will say that this is an iteration of the Sharpe, and they are not wrong because it is a ranking criterion only. It does not quantify the value added to active portfolio management. The goal of this metric for performance is to show how much extra returns got generated for each unit of risk incurred by a group of investments. The danger/risk referred to here is the systematic one measured by a portfolio’s beta. For the non-investment-savvy readers, a Beta is a measure of a portfolio’s systematic risk compared to an entire market, often the S&P 500. As a rule of thumb, stocks that boast betas of more than 1.0 get viewed as more volatile than the S&P 500. Beta also gets implemented in CAPM, or the capital asset pricing model that describes the link between the expected return for assets and systematic risk. CAPM is considered by most as an instrument for pricing risky securities.

The formula for the Treynor Ratio is subtracting the risk-free rate from the portfolio return and then dividing this by the beta of the portfolio. The goal here is to try to gauge how successful an investment will be in terms of yielding compensation to investors for taking on the noted risk.

The focal downside of the formula is its backward-looking outlook, as investments will probably behave differently than how they did so before. The success of applying this principle heavily relies on implementing quality benchmarks to measure beta.

Its inventor is American economist Jack Lawrence Treynor, a mentor of Fischer Black, one of the creators of the Black–Scholes model, and a protégé of the 1985 Nobel Memorial Prize in Economics winner, Franco Modigliani.

Benchmark Returns with Indexes

Being able to continuously measure the performance of multiple investments at any given time delivers a substantial advantage in the process of trading securities. Thankfully, that can be done nowadays using various software that can create different kinds of charts and tables using automatically updated data in seconds.

The terms indexes and benchmarks are often utilized interchangeably by both laypeople and casual investors. Yet, they are unique ones that delineate different things. An index is a statistical tool designed to gauge market performance over time. For example, the DJIA, or Dow Jones Industrial Average, is a securities index created to assert the accomplishment of stocks representing a significant chunk of the US economy. While a benchmark, by definition, serves as a standard, a reference point by which other things get judged.

With a portfolio management app, users can set up benchmark columns to track a stock’s performance vs. its index. Note, by default, most investing software will use the S&P 500 index as a comparison benchmark, but that can get modified in a setting’s window.

Also, today, investors have multiple benchmarks to choose from in apps. Some of these are fixed-income and traditional equality benchmarks. Plus, users have more exotic ones on hand, invented for real estate, hedge funds, derivatives, and other types of investments. But explaining these is outside the scope of this article.

In general, most investors look at broad historical indexes as benchmarks when evaluating how their trades are doing. Those investors that own stocks frequently, if not religiously, check out the Nasdaq 100, the mentioned DJIA, and the S&P 500 to see – where the market is at. That is simple, even without an app, because these indexes get tracked by worldwide financial media outlets. Active management investors must ensure that they are implementing proper benchmarks that their returns get compared to at distinct intervals. And sadly, research shows that most actively traded portfolios fail to beat benchmarked indices after factoring in taxes and fees. Thus, that is the reason so many people claim that it is wiser to take the passive indexed route to invest practices.

Jensen Measure

Michael Cole Jensen is an Alma mater at the Macalester College University of Chicago and has worked in economics for sixty years, teaching at Harvard University and the University of Rochester during his illustrated career in American economics. In academic circles, he gets credited for playing an essential role in corporate governance, stock option policies, and capital asset pricing models. Though, by far, his most massive contribution to finance gets considered the so-called Jensen’s alpha/measure.

What is Jensen’s alpha? It is another risk-adjusted performance measure, an ex-post alpha that gets utilized to figure out the abnormal return of a portfolio/security over the theoretical expected return. The theoretical return most commonly gets predicted by the capital asset pricing model, but other market models can be used that incorporate statistical methods to predict the appropriate risk-adjusted return of an asset. As discussed above, the capital asset pricing model, or CAPM for short, uses beta as a multiplier. So, Jensen’s measure quantifies the excess returns accrued by a portfolio above the returns projected by the capital asset pricing model.

The formula for Jensen’s alpha is taking the portfolio return and taking away from it the total of the sum of the risk-free rate when one adds to it the beta multiplied by the total of the expected market return with the risk-free rate subtracted from it. That may be a bit complicated for some to grasp in text form and require further exploration. But, the value of the alpha can be positive – showing outperformance, negative – displaying underperformance, and zero – neutral performance.

Critics of Jensen’s measure generally state that the disadvantage of this approach is that it does not take into account the portfolio’s volatility, only its expected return. And it misses out on attributes like skewness and kurtosis, pointing to Eugene Fama’s efficient market hypothesis (EMH) as something fans of Jensen’s measure should look into and analyze.

Parting Thought

These and other tools can deliver pivotal information to investors regarding how effectively their money is working for them. Remember, portfolio performance measures should have a determining part in future investment decisions, but they only show part of the story. Just because stocks are not doing well at the moment or for the past several months, that does not mean they have little long-term value. So, there is something to be said about having long-haul perspectives and beliefs in specific companies, ones that may be on the verge of innovating or those whose accurate value will only get recognized down the line. Still, without adequately assessing risk-adjusted returns, no one can view the entire investment big picture. Not having such sight can indirectly lead to misadvised decisions that can have dramatic consequences. Therefore, it is smart to measure performance periodically.