How to Use Risk-Adjusted Performance Metrics to Evaluate Portfolio Performance
Striking a balance between risk and return is essential for investors. But looking solely at returns may be deceptive; an increase in returns could conceal significant volatility that impacts performance.
Risk-adjusted performance metrics provide a more holistic picture of an investment portfolio’s performance and this article will present several of them, such as Sharpe Ratio, Sortino Ratio and Beta.
M2 Measure
The M2 Measure is an accessible risk-adjusted performance metric used to compare the relative return of a portfolio with its benchmark. This measure is calculated by dividing Sharpe ratio by standard deviation of benchmark, then adding the risk-free rate – this formula allows traders to easily compare risk adjusted performance of portfolios of differing degrees of volatility side-by-side.
Calculating M2 Measure is straightforward using this formula: SR = Sharpe Ratio/(SR + Benchmark Standard Deviation)/(SR + Risk-Free Rate). However, its calculation depends on your choice of benchmark portfolio and risk-free rate; to get accurate results it’s critical that they accurately represent your investment portfolio’s risks characteristics.
M2 Measure has one major flaw – it relies on the assumption that returns have normal distributions, leading to inaccurate assessments of risk-adjusted performance when returns have an atypical pattern, such as skewness or kurtosis.
Due to its limited scope, the M2 Measure fails to account for other factors that can have an effect on portfolio performance, such as taxes, transaction costs, or liquidity constraints. As such, it is recommended that other performance measures like Sharpe ratio, Jensen’s alpha or Sortino ratio be utilized alongside M2 Measure for an in-depth view of portfolio performance.
Sharpe Ratio
Sharpe Ratio is one of the most useful metrics when it comes to evaluating portfolios. This ratio compares a portfolio’s return with that of an investment with virtually no risk, helping you understand whether your manager is offering adequate compensation for taking such risks.
To calculate the Sharpe Ratio, begin by calculating your portfolio’s returns over an established time period (usually one year), including any reinvested dividends or interest. Subtract beginning value from ending value to determine total change percentage – then express this number as a percentage value.
Subtract the risk-free rate from your portfolio’s return, typically calculated using Treasury bond yield, then divide by standard deviation to determine excess return – higher numbers indicate better portfolio performance while lower ones suggest worse ones.
However, it’s important to keep in mind that the Sharpe ratio only measures historical data and cannot guarantee future performance. Furthermore, its inability to differentiate between upward and downward fluctuations may prove misleading when comparing strategies with differing levels of volatility. Therefore, for best results it may be advantageous to combine it with other performance metrics like Sortino Ratio or Treynor Ratio which account for both up and downside volatility; such metrics may prove especially helpful when analyzing strategies incorporating leverage or other elements that increase potential risk levels.
Sortino Ratio
The Sortino ratio is similar to the Sharpe ratio, except it considers downside volatility when making calculations. Created by Frank Sortino and commonly used to evaluate mutual funds, stocks, and individual securities; its primary focus being risk of loss for conservative investors and traders. Sometimes combined with other performance metrics to provide a complete picture of an investment’s risk/return profile.
Sortino Ratio offers several advantages when applied to investing, such as taking into account both returns and downside risk potential to give a more accurate picture. Unfortunately, however, its use cannot take into account specific distribution of returns so may be less reliable than other performance metrics and relies heavily on historical data – which may not accurately forecast future performance.
Sortino ratios are useful tools for evaluating investments with high risks but promising returns, particularly when combined with other performance metrics. They’re not recommended, however, for investments which are illiquid or volatile such as commodities, privately owned companies, some hedge fund investments or long/short strategies; their historical data-reliance can lead to inaccurate measurements for investments that experience extreme market movements; regardless, it’s vitally important that investors regularly assess risk and return in order to stay on track with their goals and avoid major losses.
Beta
When evaluating a portfolio, it’s essential to look at its performance over a specified time period and compare that against similar investments. This allows you to assess if an investment strategy suits your goals and risk tolerance – such as retirement savings or saving for college tuition – properly. Once all necessary information has been compiled, calculate its change by subtracting its beginning value from its ending value, multiplying by 100 and expressing as a percentage result.
Beta provides an accurate assessment of risk for any stock. A stock with a low beta is more likely to follow market direction and experience smaller price movements; on the other hand, stocks with high beta can experience more price swings if the market drops drastically.
Capital Asset Pricing Model’s (CAPM) measure helps you select a portfolio with maximum returns for desired levels of risk, but its application may be limited due to its reliance on historical data, which doesn’t account for qualitative factors that might influence future returns – such as entering new businesses or taking on debt – which may change its risk profile significantly over time.