How To Measure Portfolio Performance

How can I tell how well my portfolio is performing?   Through this podcast, it's Richard Oring's goal to educate listeners about managing their money.  Today, he and Jag look at different ways to evaluate the performance of your portfolio.

First, it's important to understand your strategy and overall objective - is it retirement, savings or something else?

Next, we look at total return- and the elements that come together to give you a total return. Then, what time periods do we use to evaluate total return?  And what benchmarks can we use in this analysis?

Rich then breaks down some market turns in a way for us to understand, including standard deviation, beta, alpha, R-squared, Sharpe Ratio and Sortino Ratio.

More: https://www.investopedia.com/
https://seekingalpha.com/


To talk to Rich thee terms or anything related to your financial future, reach him at (609) 924-2049, extension 126,  go online to https://ncfg.com/, or send Rich an email.  ROring@ncfg.com.

Transcript

Gag:

Welcome back to Financial Matters with Richard Oring. I am John Gag, joined as always by Richard Oring from New Century Financial Group. Rich, good to be back with you, as always.

Rich:

Gag, it's great to be here. We're going to talk about a topic which I've been wanting to do for a while. I'm glad we follow your sitting down and going to record it.

Gag:

Yeah. You mentioned this to me off air, as we were planning out the show today, and I know you are very savvy on the technical side of things, and we're going to talk about ways to measure portfolio performance today. We're going to get a little bit on the technical side, but if you're listening, I don't want you to worry, because I'm going to make sure that Rich explains this on a level that I can understand and as the proxy for the listener. So if I can follow Rich and understand him, you'll be able to follow him. So we're going to keep this pretty elementary, but it's really important stuff to talk about.

Rich:

Gag, let's go one step farther. I don't want anyone to listen to this podcast and think that they're going to be a technical and fundamental analyst on their own portfolios. This is just enough information to get you started, so you can continue doing a little bit of extra research on your own. It's not complicated stuff, but a lot of people will come to me and say, I don't even know where to start to look if an investment or a stock or a mutual fund, or my portfolio held at Vanguard, is allocated properly. Can you help me at least get started? And that's what the purpose of this podcast is, not to make you an expert.

Gag:

So the question is, where do I start? The answer is, right here with this episode of the podcast. Got it.

Rich:

Love it.

Gag:

A lot of times we make decisions, we just hope for the best, we trust without knowing how to evaluate, how these portfolios are doing, who's managing it, just like you said. So where do we start with our whole explanation here?

Rich:

All right, we're going to break this down, but let's talk about the very first thing. You have to have a purpose for the account you're going to be investing in.

Gag:

Okay.

Rich:

And you can have multiple accounts. You can have a retirement account. You can have a 529 plan for college savings. You can have an account, I'm already putting money in the retirement, I'm already funding my college plan. I just want to have a general savings account, which can earn money, higher interest or dividends than I can get at the bank.

Gag:

For my walking around money. Yeah.

Rich:

Walking around money. But each of those objectives of that account should have a time horizon and a risk associated with it.

Gag:

And if I understand this correctly, you can take greater risk with money you're worried about longer term, and you got to be more safe with the money that you might need access to, short term. Correct?

Rich:

Exactly. I always say time will help reduce some volatility. If you look at your account every day, you'll see volatility.

Gag:

Especially in 2022.

Rich:

Exactly. If you spread it over three months, you'll see volatility. If you spread it over three years, the numbers get closer.

Gag:

Assuming you get on that graph. Got it. Okay.

Rich:

The next thing you want to really consider is the risk. I'll give you a little story. I remember when I bought my first condo, I had a mutual fund, which is no longer even available, but I mentioned in a previous podcast, my dad was a financial advisor and he put my money into a large cap growth fund.

Gag:

I've heard that term.

Rich:

Yeah. Well, you remember the time period of the tech bust?

Gag:

Oh, the end of the 90s, early 2000s. Yeah.

Rich:

Yeah. And I lost 54% of that value when I was buying my first condo.

Gag:

Oh, oh, that's brutal.

Rich:

So I had all this money for the down payment, I thought. Again, I was not in the business at the time. And when I found out that it wasn't there after I found my condo, I learned real quick how to scramble and try to make the deal work.

Gag:

Yes.

Rich:

What would've been nice, is having a risk tolerance question, which would've been asked to me. Not parents just do things for their kids. And the communication probably would've reduced some of that risk before this happened.

Gag:

Right. Like, "Hey, I'm going to need this money in X amount of years, because I want to get into a condo and purchase a condo. Let's make this a little bit less volatile, a little bit less risky so that I have access to more of it, or more of it exists when I need it."

Rich:

Exactly. So being able to assess the risk for each account, a lot of financial advisors will do one risk questionnaire for the client, but they don't assign that risk questionnaire maybe for each goal.

Gag:

Yeah.

Rich:

That risk is going to be different for something I'm going to need in two years or 30 years.

Gag:

That's a really good point, because I think a lot of our listeners have gone in and sat with a financial advisor. Okay, one to five. How conservative versus aggressive do you want to be? And that's what they apply to everything. But that's a really good point there, that I might be willing to be more aggressive with long term money. I might need for my retirement, I'm 41 years old. I'm probably going to retire in 20 years. I can be a little more aggressive with that, as opposed to if my wife and I want to buy a new house in two or three years, we want to be a little bit more conservative with that money. So, that time horizon risk makes a lot of sense.

Rich:

I first got in the business, we didn't really have risk questionnaires. I would say something like this. Tell me what your risk tolerance is from aggressive to conservative. And I know you don't know what I mean by that, so let's go with this. Conservative be, you'll open your statement, this is like before online, everyday checking. You'd open your statement, and you had your coffee in your hand and you spilled it, because you lost money. Aggressive would be, you got the statement, you never even opened it. You threw it right in the garbage can.

Gag:

Right.

Rich:

I mean, that's how I used to assess risk. Now, fast forward all these years, I use different risk questionnaires based on the client sometimes. My standard one will be looking at what are they willing to lose for an upside potential. And we go through a whole bunch of questions to figure out how to get that number. Or I have clients who really have a hard time answering that, but I need to understand how they are thinking. And the new thing in our industry, is behavioral finance risk questionnaires. And I have the ability to run those questionnaires. And those are going to be more conversations afterwards on how you look at money, how you look at risk. And then what's interesting is, I will also then give it to their spouse, because they can be different.

Gag:

Oh, very different a lot of times. And you want to make sure that you're on the same page.

Rich:

The worst thing you can do, is come to me and tell me that you're really, really ultra conservative. You're 30 years old and you don't save enough, and you're not willing to take risks. Because my job is, I'm going to say this to you, "Look, this is your risk talk. You're conservative. This is how much you have, and this is how much you have available. You will never get to your retirement. So you have choices, reduce what you think your retirement's going to look like, or you're going to have to increase risk." And we're going to have to document that conversation, because we're going off, the risk talk is going to be invested differently than what the risk questionnaire basically said. And that's a conversation sometimes we have to have. We can't just take it for granted that the client says they're conservative, and that's going to be the right allocation to get them to meet their goals. Sometimes they don't match. And that's our job to figure that out.

Gag:

It's almost like you work backwards. And you said a moment ago about your goals, and you say, "Okay, I want my goal for retirement is this. How do I get to that goal? I need to have some sort of aggressiveness and risk tolerance to be able to grow the money to this amount." And that does involve risk of course, on the downsides. That's a really good point. All right. What's the next on our list to talk about, Rich?

Rich:

So let's go with total return.

Gag:

Okay.

Rich:

You look at performance numbers, you don't know how it's made up. So there's a number usually reported, you'll see Morningstar, your 401(k) selections on Yahoo Finance, wherever you're looking. It's usually the reporting total return. So total return is capital appreciation. That is, you buy something for $10, it's worth $15. There's $5 in capital appreciation.

Gag:

Got it.

Rich:

Dividends. If you're having a stock and they pay dividends, which is like giving some of the income to the shareholder, you have to add that in interest. Some investments, like bonds, pay interest. If you own mutual funds, they will pay distributions capital gains, which are embedded in the mutual funds, which they will disperse out once a year usually.

Gag:

Okay.

Rich:

All right. You have to add all that up to figure out the total return. So let's just make it simple. It's all income and capital appreciation, add the two, and that's usually your total return.

Gag:

It's all your income, plus any growth and value. Got it.

Rich:

Then you have to look at the time period. So total return is usually looked at a rolling one year. So if you're looking at July to July, whereas year to date is another common one, that'd be January to now, quarterly or monthly. You also have to look at the reporting date. So mutual funds may not report their performance numbers every day. If you're looking at Morningstar, it's audited numbers. So if you're looking at, the June 30th numbers might come out July 10th.

Gag:

Okay.

Rich:

So usually they'll disclose that somewhere. If we're looking at longer time periods, let's say three years, five years, 10 years, sometimes you'll see INCP, that's inception. So when that investment came out, those are usually annualized rate of returns. So they're taking the average rate of return, making it annualized. Does that make sense?

Gag:

Yes. Okay, so what's next.

Rich:

All right. So now that we understand what total return is, and we know we have our risk, our goals and all that outlined, we have to look at the next thing, and that is a benchmark. So my mutual fund did 10%. Okay, what did the market do?

Gag:

Ah, okay.

Rich:

Or something similar to it. I'm not going to use the market to benchmark a bond portfolio, that wouldn't be fair. So we need to pick a benchmark. And a benchmark can be multiple different things. It could be unmanaged indexes, which are very common. You can actually benchmark using another mutual fund or another stock, which is similar to the investment you're looking at. But again, most likely the unmanaged indexes are what most people use. You've probably heard of the S&P 500. You might have heard the ag, which is the Aggregate Bump Index.

Rich:

That's actually an ETF from Barclays NASDAQ, which is, if you were looking at ETF, that would be queues, but they report it as an index also. But an index is basically a pool of investments that are not sold and bought unless the criteria of a stock makes it come out of that. Meaning, let's say you're a large cap company in the S&P 500, and then your market capitalization went down, moves you to midcap. Well, the S&P 500 is going to remove you and put something else in there. It doesn't happen often. Might be once a year, could be one or two changes.

Gag:

Okay.

Rich:

All right. So, there's other things you want to look at now that we got a benchmark and we got your total return, and we now know what your risk is and things like that. So we're going to talk about things like standard deviation, beta, alpha, R-squared, Sharpe ratios, Sortino ratios. How often should we be looking at? It sounds like a lot, but we're going to make this simple.

Gag:

Oh, I hope so. Because you're talking alpha, beta, like you're taking me back to why I didn't pledge your fraternity at Syracuse here.

Rich:

Yeah. I mean, in previous podcasts, I've heard about your college experiences.

Gag:

Yes. I didn't need a fraternity to make a lot of dumb decisions at college. Okay, let's start with the first one that you listed there. I know this is important, but I need you to break it down for me, and that is standard deviation.

Rich:

Okay. So again, when I'm explaining this, I'm going over it very broadly. I encourage everyone after the podcast, go back to it and say standard deviation. Let me go online and let me do some research. It's a formula. I'm not going to be doing advanced math classes on a podcast.

Gag:

Okay, good.

Rich:

You can go Google it.

Gag:

As I've mentioned, I'm a communications major. I appreciate that. So continue.

Rich:

So standard deviation is a statistical measure of volatility. It's complex, but basically what it does is, it shows a variance in the price. The higher the number, the higher the standard deviation, meaning there's a larger gap in the price movements.

Gag:

More volatile, higher highs, and lower lows.

Rich:

Exactly. Usually high standard deviations, will be found in your growth stocks. Your low standard deviations usually will be found in your blue chip stocks.

Gag:

More stable. Okay.

Rich:

Yeah. So when we go over a few of these things, we're going to be talking about volatility, and you might be saying to yourself, aren't they the same? There are slight differences in why you would use one over another one, or you might want to use them both. Again, we're not going to go into that great of detail.

Gag:

Okay.

Rich:

Let's talk about beta. I like beta. I use beta a lot. Beta is a Cisco risk metric again. Again, if you want to know how it's calculated, feel free. Our financial calculators can help us do it on the fly, where it's reported in every single report we subscribe to. But again, here's the difference. A beta, we need a benchmark to compare it to. So when we're looking at beta, and let's just say, we're looking at the Standard and Poor's 500 as a standard benchmark, beta will always be one for the benchmark.

Gag:

Okay. So, we're starting off at the number one, 1.0, that's our starting point.

Rich:

That's our benchmark.

Gag:

We're setting our benchmark as the 1.0 and the beta is going to be how far it varies either way from the one, right?

Rich:

That's correct. So if the beta on the stock mutual fund, ETF or the portfolio is less than one, it's less volatile. So if it was 0.8, it's about 20% less volatile than the benchmark is. If it's 1.2, it's 20% higher volatile, and you would think that they should move. If the benchmark went down 20, you would think your portfolio would be down 20% also. It's not always the case, but that's the quick analysis of looking at beta.

Gag:

Okay. So beta is volatility compared to a benchmark. Okay, I'm with you.

Rich:

And usually with the beta, we're looking at a longer time period. We're looking at maybe a three year beta number, where we're looking at three years of history, or five years. You can even go 10 years. At some point, you're going too far. It's not worth even looking at.

Gag:

It's not relevant at that point.

Rich:

I like to look at three year beta. So I said, usually you would expect your portfolio stock to move correlated to that beta number. There's another term we call alpha, another long calculated formula. You can Google if you're that kind of math person. Again, we need a benchmark. But we like to make things a little bit more difficult and confusing. Unlike beta, where we start with one, we start with zero with the benchmark.

Gag:

All right.

Rich:

So basically, alpha is the performance difference between the portfolio and the index. So I'll give you an example. If we're using the S&P 500 and the alpha of the portfolio is two, then we would expect the portfolio would've performed 2% better using historical data for a time period. Again, that three or five year number. So think about it, you couldn't actually beat the S&P 500 we're using as a benchmark with lower beta, as long as we have a high alpha.

Gag:

Okay. Makes sense.

Rich:

That's your perfect portfolio right there in my mind.

Gag:

So, that's what you want. Lower beta, higher alpha is where you want to be ideally.

Rich:

Right. When I say that's a perfect scenario, I mean, that's a perfect... If you have those two things, you know you should keep doing some research that you probably found something good.

Gag:

Okay.

Rich:

But you still, for compliance reasons, continue doing your due diligence.

Gag:

Of course. Yeah.

Rich:

All right. So low beta, high alpha, perfect situation. And you can use alpha and beta. Again both, you can use it to review a portfolio. You can use it to look at individual holdings. You can use it to look at ETFs. So Gag, what I recommend now that we just learned the very basics, we learned what total return is. We know we can compare that to an appropriate benchmark. So give you an example, if you're looking at your 401(k) plan and you have a large cap growth fund, look for a benchmark which is large cap growth. Give you an example, the Russell 1000 Growth Index.

Gag:

So you want to compare apples to apples when you're talking about alpha and beta.

Rich:

Correct. Usually you can Google that investment, and they'll tell you what to compare it to.

Gag:

Okay.

Rich:

So now you can compare, hmm, an index did 10%. My manager did eight, and I'm paying this manager. I'm talking about the mutual fund manager. I'm paying for this, and maybe I'm paying the advisor for giving me advice too. I'm paying two times, and underperforming the market. Now, are you always going to beat the market? No, but over time, you're hoping to get some value for what you're paying for. It's like going to buy a large soda at the movie theater, and they only filled it three quarters way.

Gag:

Yeah.

Rich:

At some point you're going to say something.

Gag:

I want all 500 of these calories, damn it.

Rich:

Exactly. So start off with your four. Okay, look at your total return. Compare it to a benchmark. Look at the beta. Look at the alpha. Now, when they offer five different large cap growth mutual function in your 401(k), you can look at it with totally new eyes than just what you did probably earlier was, looked at last year's performance, ran your finger down, looked at the best one, and that's what you chose.

Gag:

Right. The dark board approach. Yeah, exactly. So alpha, beta and benchmarks are really good to know. You also mentioned off the top, a couple ratios you wanted to talk about too, right?

Rich:

Yeah. Let's start with Sharpe ratio. Again, really complicated formula. You're more than welcome to go research. By the way, there's a great website. Investopedia has everything on here. Another great website you can use is, Seeking Alpha. They do have a page description though. I mean, those are great resources. I mean, unbelievable dictionaries they built for investments and financial planning. It's great. I mean, even as a professional there's times where I sometimes go to it and look something up.

Gag:

Okay.

Rich:

All right. So Sharpe ratio is there to use, again, to understand a return and risk. So we're looking at the return, less than the risk free rate. Okay, make it simple. If I know I can go to the bank, and let's just say, I buy a US treasury or a CD, whatever we want to use, which is risk free, and let's say I get 3% on that. With this calculation I can use, I can figure out what the Sharpe ratio by looking at historical returns and deviations and all that kind of fun stuff. They figure out the Sharpe ratio, and it gives me what the return is above the risk free. So if I'm getting 4%, I'm really only getting a 1% over the risk free.

Gag:

Because you already started three. You only went up one to four. Okay.

Rich:

Right. I may not have owned the treasury, but I know I could have had that opportunity to buy it. Really simple, if you're looking at the Sharpe ratio and we're looking at a three year number again, you look for anything above a one. Then we have the Sortino ratio. It's a playoff on the Sharpe ratio. The difference is, it doesn't look for the upside of the investment or the portfolio, it only looks at the downside risk.

Gag:

Okay.

Rich:

Like my investment strategy. If you're using someone who invests money, ask them how they invest money. I look at the maximum draw downs and how much a portfolio can go down during volatile times.

Gag:

Sure.

Rich:

So this would be something very important for me to look at. I like this ratio, again, you want to look for something which is one or higher.

Gag:

Okay. So I want to make sure I understand this correct, because I'm a little bit confused here. So Sharpe ratio is the upside, you want to be above one.

Rich:

It's the up and down.

Gag:

The up and down. Okay.

Rich:

Correct.

Gag:

But Sortino, the downside, you also want to be higher than one here?

Rich:

It's just a ratio number. It's a calculation to give you a number. So if the number is one or higher, that's usually considered good. The higher, the better.

Gag:

Okay. For both of them. Got it.

Rich:

Correct. That one is my personal opinion, and if you Google it, that's usually what they're recommending. One or higher is the starting point of a good portfolio investment to be looking at.

Gag:

And we'll link to some of the resources you mentioned in our show notes, Rich. But I mean, this is a pretty good basic understanding of some of the terms that can make your eyes glaze over if you throw them all at your once. I think you did a good job of breaking them down one by one today, and really understanding the why and what your goals are, and your risk tolerances for investment is. A really good starting point. And then from there, you build in, you talk about ratios and alpha, beta stuff like that. But having that why, and understanding what your goals are in benchmarks, I think is really a great place to start. So I think you did a good job outlining this today.

Rich:

What's interesting, a lot of people are doing YouTube on research and they hear about these theories or how people come up with their picks and so forth. What they're doing, and there's hundreds of metrics to be used.

Gag:

Oh, sure.

Rich:

Hundreds. What they're doing is, they take a few of these and they combine them and they back test you and they use it going forward, and they screen their stocks by using this. And that's what I do when I'm looking for stocks. I don't just... People go, "How did you find that stock?" I mean, there's stocks I never even heard of where I buy, but it's not like I don't do my research. After I get the screening done, then I start doing my research. There's a lot of things I'm looking at, institutional ownership, short interests. There's a lot of stuff you need to do. But for the average person who's looking at their investments, he'll look at a 401(k) or they want to see how their financial advisor's doing. This is a great starting point to continue on and learn from.

Gag:

I think you did a really good job, as I said, of outlining this stuff today. Rich, if one of our listeners wants to come talk to you about the basics, or about even getting involved with you as far as working with you and your firm at New Century Financial Group, what are the best ways to find you?

Rich:

Pick up the phone, call me (609) 924-2049. I'd love to talk. My extension's 126. If I'm not available, hit zero. Ask one of the ladies in my office or one of the gentlemen in my office to schedule an appointment with me. You can always shoot me an email at roring@ncfg.com. You can go directly to my website, click the link to schedule a meeting with me. That's www.ncfg.com.

Gag:

I know education is a really important thing for you, Rich, and I'm glad we got to educate our listeners about some of this stuff today. Take care. We'll talk again soon.

Rich:

Thank you.

Gag:

Richard Oring's branch office is One Airport Place, Princeton, New Jersey 08540. The branch phone number is (609) 924-2049. Security is offered through Royal Alliance Associates, Inc. Member FINRA SIPC. Advisory services offered through New Century Financial Group, LLC. A registered investment advisor, not affiliated with Royal Alliance Associates, Inc. New Century Financial Group, LLC and Royal Alliance Associates Inc. does not offer tax advice or tax services. Please consult your tax specialist for individual advice. We make no specific comments or recommendations on any tax related details.