by Stig Brodersen

1 OCT 2015
Whenever we hear about great investors, like Warren Buffett and Ray Dalio, we usually measure their accomplishments by their net worth and returns. The latter is often good for a discussion between investors. I’m a simple investor and my strategy is not to use leverage, derivatives, or any of the shenanigans, rather I simply buy and hold great stocks. For me my own performance has always been easy to measure. I look at the annual compounded return, and if I’m doing better than the market I’m usually happy with the results.

Recently however, I have asked myself if that is the right approach. Since I’m a huge investing geek, I might not be happy with the simple answer, since I know that while the value of my stock portfolio and price is closely correlated in the long run, it can vastly differ within a short time span like a year. In other words if I do 10% in my portfolio and the market only returns 8% I can’t know for sure if I’m satisfied. The reason for the popular approach of measuring portfolio performance in terms of annual returns in price is not surprising. The other discussion about intrinsic value is much more complicated, and while in theory it is a better measure, it’s a subjective measure that is built on each person’s estimate rather than on hard facts.

In my own curious/frustrated manner I set out to speak with an expert that could help me determine how to measure portfolio performance. The first person that came to mind was Wesley Gray. Preston and I had Wesley on The Investors podcast in episode 48 and 49 where we talked about investing in ETFs and even talked about how he was managing his own ETF. He recently published the book DIY Financial Advisor and I liked his discussion of managing and measuring the performance of assets.

So, Wesley gave me the bad news: You can’t find a single metric that will tell you the whole story. If you have experience with stock investing you probably wouldn’t be too surprised with that answer. For instance we like to look at the Return on Equity as an indicator for the quality of the stock, but as a stand-alone metric it’s actually close to being useless. Let’s face it: The truth is always subjective.

That is however, not an excuse for not thinking long and hard about how a portfolio is performing. So let’s dig in and see some of the more important metrics that Wes recommended.

Sharpe ratio is the most popular measure of portfolio performance
If you do a Google search for “portfolio performance” you’ll often see “Sharpe ratio” turns up. It’s no surprise as academics and portfolio managers throughout the world typically refer to it, often together with annual price appreciation/depreciation.

The equation is quite simple:

Sharp Ratio = (Annual Return – Risk Free Rate) / Volatility

Let’s go through the equation step by step. First we have the annual return, which is clearly a component where higher is better. Next we have the risk free rate. Often that is referred to as the 10 year federal bond. In other words, if you loan money to the government for 10 years, which interest can you expect to receive? The actual rate is not as interesting as the difference between the rate and the annual return.

If your stock portfolio returns 9% when you can get a risk free return of 8% it’s therefore less impressive than a 7% annual portfolio return when you can’t get any risk free return. To me I really like the intuition behind the numerator, as I also get the chance to compare returns over different time periods. If you for instance look back at the 1970s and 1980s you’ll see the dramatic impact that interest rates has had on portfolio returns. It’s therefor hard to compare your portfolio performance today with an almost non-existing interest rate.

I don’t like the denominator’s “volatility” though, and here is why: the volatility is simply the actual return’s deviation from an expected value? Confused? Well, think about a stock that drops from $10 to $5 the next day and again to $15 the day after. If you are a believer in the Sharpe ratio you would rather prefer a stock that climbs from $10 to $14. The intuition behind the ratio is therefore: “How much extra return than a risk free government bonds can I get for 1 unit of volatility?” I see volatility as an opportunity to buy stocks cheap and sell when they are expensive and in aggregate maximizing my return, rather than a game of minimizing my volatility. A leveraged portfolio might show a low volatility, but be prone to a complete default. The Sharpe ratio looks at the past or the expected future and doesn’t tell you about whether the overall investment approach is sound.

Is the Sortino ratio a better measure?
So what is the alternative to Sharpe’s ratio you might ask? I think that real risk comes from a permanent loss in capital and not in the short term volatility, so on that note Sortino’s ratio might be a better choice. The equation is similar to the Sharp ratio but with an important distinction:

Sortino Ratio = (Annual Return – Risk Free Rate) / (Downside Volatility)

As you might notice the denominator has been replaced with “downside volatility”. The interesting thing about volatility is we often think about the downside, and not the upside. That means if you have a lot of upside volatility, you are actually punishing the portfolio manager for his effort. That doesn’t make any sense right? This is the strength of the Sortino ratio since it only looks at the downside volatility. While this metric still has the inherent problem that a cheap stock is often a great buy, it provides the investors with a picture of the risk for permanent loss of capital. A low Sortino ratio is clearly a red flag for the investor as it can indicate the potential risk of permanent loss, or at least a drawback that is very hard to recover from.

As already said in this blog post it’s hard to come up with one metric. I personally like the Sortino because it’s more useful for high volatility portfolio environments where I often look for bargains. Like the Sharpe ratio it still has a similar drawback that it only tells you about the historical volatility. It doesn’t address the actual risks behind the underlying assets that make-up the numbers.

When we look at these two ratios, I’m sure many people are saying, so what’s the point? Well the point is this. Everyone wants to get good returns. In addition to that, many people want to get good returns and not ride the roller coaster of fear and greed. Unfortunately, when an investor chases abnormal returns, it also increases their risk for more volatility. That’s where these metrics come into play. The Sharp Ratio and Sortino Ratio demonstrate to investors that not only can a portfolio manager get superior results, but they can do it in a controlled and balanced manner.

So where did we land? Should you use the Sharpe ratio or the Sortino ratio and what about the less known ratios like Treyner Ratio or Jensen’s alpha that we didn’t even cover in this blog post? In the end, what I pay most attention to is the annual return over a long period of time. The reason I choose this approach is because I know all securities eventually revert to their true value. When I match that up with a sound investment approach with solid underlying assets, I think you have a simple and useful strategy for measuring portfolio performance. It’s as useful as it is powerful.

P.s. As usual, I want to hear why my analysis is wrong. If you’ve got some comments or questions about this post, be sure to leave it here on our forum.

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