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Measures to Evaluate Portfolio's Performance

October 31, 2012

Lisa Pallavi Barbora

Stocks

Performance evaluation needs to be a continuous process if you have a portfolio of marked to market securities such as equity shares. But performance evaluation isn't only about looking at portfolio returns, but also at risk. While individual security risk evaluation depends on qualitative and financial attributes of particular stocks, there are statistical measures of evaluation portfolio risk. Here are the three most common parameters.

Standard Deviation

This is the most commonly used measure to evaluate risk and essentially tells you how volatile your portfolio returns are. Standard deviation shows how much portfolio returns oscillate away from the mean return. A high standard deviation means that returns can switch from very high to very low, while a low standard deviation shows that returns don't fluctuate much and are stable. To calculate this, you need the mean or average returns for any frequency you choose, such as daily, weekly or monthly.

Keep in mind that standard deviation does not comment on whether the portfolio has outperformed or underperformed a benchmark, rather you can only tell how much returns fluctuate compared with mean returns of a portfolio.

Portfolio Beta

This measures how much your portfolio returns fluctuate compared with fluctuation in benchmark returns. It is also referred to as market risk because it measures the sensitivity of movement in portfolio returns to the movement in benchmark returns. A beta close to zero means that returns are not at all comparable with benchmark returns. Typically, a beta of 1 suggests movement similar to the market, which implies market risk. A beta higher than 1 suggests it is riskier than the market. A riskier portfolio tends to exceed market returns both on the upside and downside.

Portfolio beta helps compare the performance of fund managers or portfolios. For the same level of return if the beta of one portfolio is 2.5 and another portfolio is 1.5, it means that the excess return from the first portfolio is not enough to compensate for the high risk it is taking. Beta also considers only volatility and does not show how the portfolio has performed in terms of returns compared with the benchmark. You can use it to compare the riskiness of your portfolio against similar portfolios.

Sharpe Ratio

This considers both risk and return. Sharpe ratio is a simple way of examining the excess return (or risk premium) you make when you take risk or volatility (standard deviation) in the portfolio. This excess is the return a portfolio earns over and above the assumed risk-free rate of return. Sharpe ratio measures whether the risk taken is worth the extra return generated compared with a similar portfolio. It can be calculated using standard deviation and portfolio return.



Source: (c) 2012 the Mint (New Delhi). Distributed by MCT Information Services


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