Friday, April 20, 2007

Evaluating Investment Performance: Part 1 of 2

As many of my readers know, I love comparing individual stocks. I think it is important to evaluate stocks against one another. While all great investors do this, I do not like comparing portfolios against one another. It seems that comparing portfolios just gets too personal sometimes. While returns do give you some insight into your talent as an investor, often times they do not tell the whole story. My next series of non-stock-picking posts will be examining how to properly evaluate your performance of an investor.

Two of the most common measures of performance are the Sharp ratio and Treynor ratio. The core fundamentals behind these two measures are tracking the expected return of a portfolio over the risk the portfolio. The only difference in the calculations of these two portfolios is the value that risk takes on. The Sharp ratio is found by taking the return on your portfolio, less the risk free rate (rate of a T-Bill for example) all divided by variance in your portfolio's holdings. The Treynor ratio is found by taking that same return on your portfolio, less that same risk free rate, divided by the average beta in your portfolio (Beta can be found on Yahoo! Finance).

A talented investor is an investor that has the ability to achieve returns in excess of the average return given his/her portfolio's risk level. Let's say Investor A has achieved returns of 20% while maintaining a portfolio beta of 2 and let's say Investor B has achieved returns of 8% while maintaining a portfolio beta of .5. Who is the better investor?

Let's look at Treynor ratios. Assuming a risk free rate of 3%:
A has a ratio = (20%-3)/2 = 8.5
B has a ratio = (8%-3)/.5 = 10
Investor B is actually has a better reward-to-risk ratio and is essentially more talented as an investor.

So next time when you compare returns, you may want to look into which investor has the higher reward-to-risk ratio as well.

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