In a couple days I will be sharing my year-to-date investment performance (oh yea) but before I do so I want to finish up this series on investment performance indicators. In Part One of the series I discussed different ratios that measure excess return from the amount of risk you are taking on. The key point with these ratios is that investor A may have a higher return than investor B, but investor B may be more talented because he/she is taking on significantly less risk than investor A.
Another performance measure I want to introduce measures an investor's ability to time bull/bear runs successfully. The main concept behind these measures simply state that an investor should bear more risk (have a higher beta) when the market is doing well and bear less risk when the market is doing poorly. This standard equation used to measure timing ability:
Ri,t – RF,t = ai + βi,M (RM,t – RF,t) + βi,MM (RM,t – RF,t)2. Where the left side of the equation signifies the excess return of the portfolio, the yellow text shows the market's excess return, and the green text signifies the squared market premium. The equation simply shows that if your squared market premium (green factor) is positive, you are doing a good job.
Here's a quick example. Let say the market went down 10% this year and investor A shorted the market with a beta of .5 and investor B went long in the market with a beta of 1. Investor A would have a positive timing component because he has a negative beta by going short in a market with negative returns, while investor B would have a negative timing component because he has a positive beta in a market with negative returns.
There are an array of other ways to measure performance, but I think these two are the most widely used. Again the goal of this series of posts was to instill the point that talent in investing is not solely measured in your percentage return, but how you are performing in the face of risk and how you are performing in the current market climate.
Another performance measure I want to introduce measures an investor's ability to time bull/bear runs successfully. The main concept behind these measures simply state that an investor should bear more risk (have a higher beta) when the market is doing well and bear less risk when the market is doing poorly. This standard equation used to measure timing ability:
Here's a quick example. Let say the market went down 10% this year and investor A shorted the market with a beta of .5 and investor B went long in the market with a beta of 1. Investor A would have a positive timing component because he has a negative beta by going short in a market with negative returns, while investor B would have a negative timing component because he has a positive beta in a market with negative returns.
There are an array of other ways to measure performance, but I think these two are the most widely used. Again the goal of this series of posts was to instill the point that talent in investing is not solely measured in your percentage return, but how you are performing in the face of risk and how you are performing in the current market climate.
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