Portfolio evaluation is an essential aspect of investment analysis. It involves assessing the quality of investment approaches and determining changes to improve investment results. 

A portfolio combines investment products, including bonds, shares, securities, and mutual funds. Experienced portfolio managers customise this combination based on the client’s risk tolerance to create a long-term return portfolio. 

Performance evaluation is necessary for both investors and portfolio managers. Portfolio management uses evaluation to assess the manager’s portfolio performance and determine their compensation. 

Investors can assess portfolio performance by comparing it to a relevant benchmark within the specified category and determine whether it has outperformed, underperformed, or performed comparably. A well-balanced portfolio minimises risks, grows in value, shields investors from loss, and improves liquidity.

How to Evaluate Your Portfolio?

When evaluating your portfolio, it’s crucial to consider both the returns you’re earning and the risks you’re taking to achieve them. High returns alone may not justify taking on high levels of risk. Here, we have discussed some of the most commonly used methods that comprehensively understand your portfolio’s performance.

Traditional Method

The traditional method is pretty straightforward as it focuses on measuring the returns generated by the portfolio compared to a standardised reference point. However, the traditional portfolio evaluation method does not consider the risks taken.

To address this limitation, risk-adjusted techniques have been developed to evaluate portfolio performance. 

Treynor’s Measure

The Treynor measure, first introduced by Jack L. Treynor, is a performance metric that assesses the risk-adjusted return of an investment portfolio by evaluating the portfolio’s return per unit of systematic and assumes that the portfolio has already eliminated unsystematic risk.

Treynor’s measure = (R_P – R_F) / ß

where,

R_P – Portfolio Return

R_F – Risk-free rate of return

ß – Beta coefficient

A higher measure indicates better portfolio performance. 

Sharpe’s Ratio

In 1966, William F. Sharpe developed the Sharpe ratio as a tool to evaluate the risk-adjusted return that considers both the standard deviation of the portfolio’s returns and the risk involved in achieving that return.

Sharpe ratio = (R_P – R_F) / σ_P

where,

R_P – Portfolio Return

R_F – Risk-free rate of return

σ_P –  Standard deviation of the portfolio’s returns

A higher Sharpe ratio reflects a higher risk-adjusted return.

A well-diversified portfolio will have a lower standard deviation and a higher Sharpe ratio than a concentrated portfolio with the same return. It also assumes that investors are risk-averse and prefer lower risk and higher return.

Jensen’s measure

Based on the Capital Asset Pricing Model (CAPM), the Jensen measure measures how much return a portfolio generates above the expected return from the market. The excess return generated by the portfolio is also known as alpha.

Jensen’s α = R_P – [R_F + (ß) * (R_M – R_F)]

where, 

R_P – Portfolio Return

R_F – Risk-free rate of return

R_M – Market rate of return

ß – Beta coefficient 

A consistently positive alpha indicates that the portfolio is performing above average, while a negative alpha signals that the portfolio is underperforming.

The measure calculates risk premiums in beta, representing systematic risk. Therefore, this ratio is best applied to an investment that is already adequately diversified.

Tips

When evaluating your portfolio, there are several tips to keep in mind.

1. Assessing how you have allocated traditional assets in your portfolio is essential.
2. High-risk investments provide high returns, and it is important to keep a check on the volatile rates and invest where you can profit the most.
3. It is important to remember that expensive investment products can deplete a portfolio over time. 
4. Comparing how your fund or stock behaves relative to others in the same industry or sector can help you make informed decisions about your portfolio.
5. Regularly making the necessary updates and tweaks to your portfolio is important.

By following these tips, you can effectively evaluate your portfolio and make informed investment decisions.