Question: How can we determine if our portfolio is underperforming?
Investment Goals:
Short-Term (1-3 years): Consider preserving your capital and generating a modest return, e.g., 2%-4% per year.
Medium-Term (3-5 years): Aim for capital appreciation and income, with a target return of 5%-7% per year.
Long-Term (5+ years): Focus on capital growth and consider a target return of 7%-10% or more per year.
Suitable Benchmarks:
Short-Term: Savings account interest rates or a low-risk bond index (e.g., Bloomberg Barclays U.S. Aggregate Bond Index).
Medium-Term: A mix of stock and bond indices, e.g., a balanced fund benchmark (e.g., 60% S&P 500 Index + 40% Bloomberg Barclays U.S. Aggregate Bond Index).
Long-Term: Stock market indices like the S&P 500 or a broad global equity index.
Measuring Returns:
Calculate absolute returns as the percentage change in the portfolio value over a specific period. Compare these returns to the benchmark's returns for the same period.
Assessing Risk-Adjusted Returns:
For simplicity, consider using the Sharpe ratio, which measures risk-adjusted returns. A Sharpe ratio above 1 is generally considered good.
The Sharpe Ratio Explained:
1. Return from Your Investment:
This is the profit or return you've earned from your investment over a specific period.
For example, let's say you invested $10,000 in a stock portfolio, and after one year, your portfolio is now worth $11,000. Your return from your investment is $1,000.
2. Risk-Free Rate:
The risk-free rate represents the return you could earn from a completely safe, low-risk investment. It's typically based on government bond yields, such as U.S. Treasury bonds.
You can find the current risk-free rate by checking financial news or government bond rates. For our example, let's assume the risk-free rate is 2%.
3. Standard Deviation of Your Investment's Returns:
The standard deviation measures the variability or risk of your investment's returns. You'll need historical return data for your investment to calculate this.
Let's say you have monthly returns for your investment over the past year: 3%, 2%, 5%, -1%, 4%, 6%, -2%, 1%, 0%, 3%, 2%, 4%. To calculate the standard deviation, you can use spreadsheet software like Excel or financial calculators. For our example, let's assume the standard deviation of your investment's returns is 8%.
Now, we can plug these numbers into the Sharpe Ratio formula:
Sharpe Ratio = (Return from Your Investment - Risk-Free Rate) / Standard Deviation of Your Investment's Returns
Sharpe Ratio = ($1,000 - 2%) / 8% = 0.125
In this example, your calculated Sharpe Ratio is 0.125. This means that for each unit of risk you took (as measured by the standard deviation), you earned an excess return of 0.125 units above the risk-free rate.
Portfolio Allocation:
For beginners, a basic diversified portfolio might consist of 70% in a stock market index fund (e.g., S&P 500) and 30% in a bond index fund. Rebalance your portfolio annually to maintain this allocation.
Numbers and Time Frames:
Short-Term: Assess performance every 6-12 months. A realistic goal might be a 2%-4% return annually.
Medium-Term: Review performance annually. Aim for 5%-7% annual returns.
Long-Term: Reevaluate every 1-2 years. Target returns of 7%-10% or more annually.
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