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Performance & Risk Metrics BullGlobe

Performance & Risk Metrics

What does investment performance mean?

In the investment world, performance is essentially translated to returns (gains or losses) on your investment and the progress of those returns over time.

Beginning Balance

The Beginning Balance is the money you started investing with. In our portfolios, we set a hypothetical beginning balance of $10,000; however, you can start investing with pretty much any capital. There are many great investment brokers that allow you to invest as little as $10-$50.

Ending Balance

The Ending Balance is the money you have amassed at the end of your investment period (or holding period). In our analysis, we use a holding period of 5 years. However, your holding period may be shorter or longer, depending on your goals.

Cumulative Return

The Cumulative Return is the money you made (gains/profits) or lost (losses) on your investments over a specific period of time. It is the change of value of your investment over time and it can be expressed in money terms or in percentage terms.

CAGR

Compound annual growth rate (CAGR) is the rate of return that would be required for an investment to grow from its beginning balance to its ending balance, assuming the profits were reinvested at the end of each year of the investment’s lifespan.

The compound annual growth rate isn’t a true return rate, but rather a representational figure. It is essentially a number that describes the rate at which an investment would have grown if it had grown the same rate every year and the profits were reinvested at the end of each year. In reality, this sort of performance is unlikely. However, CAGR can be used to smooth returns so that they may be more easily understood when compared to alternative investments.

Alpha

Alpha also compares an asset to its market. However, beta measures the volatility of that asset compared to the volatility of the market. Alpha is used to measure the risk-adjusted performance of an asset compared to its market.

Ultimately, we use alpha to figure out if we are being compensated for taking on more or less risk than the markets. 

An alpha higher than zero implies that our investment has outperformed its market on a risk-adjusted basis. An alpha of zero means that our investment generated returns that are exactly adequate for our level of volatility if compared to the market. An alpha below zero is a sign that we are taking too much risk for the returns we are getting and we are underperforming the market.

Standard Deviation

This is the most commonly used risk metric in the finance world. It is a simple statistic that measures the dispersion of your investment returns from their mean. In other words, it measures the distance between your returns and the average return of your investments. So, if an asset has huge swings in value (both up and down), its standard deviation would be higher than an asset whose value is steadier and fluctuates less.

Downside Deviation

Downside deviation is a measure of downside risk that focuses on returns that fall below a minimum threshold or minimum acceptable return (MAR). It is used in the calculation of the Sortino ratio, a measure of risk-adjusted return. The Sortino ratio is like the Sharpe ratio, except that it replaces the standard deviation with the downside deviation.

Sharpe Ratio

The Sharpe Ratio is ultimately a measure of expected return (in excess of any riskless returns) per unit of risk; hence we call it a measure of risk-adjusted returns. Therefore, the higher the Sharpe ratio the better, as higher returns will be generated for a relatively low amount of risk. Generally, a Sharpe ratio below 1.0 is considered low, 1.0 or above is good and 2.0 or above is very good.

Sortino Ratio

The Sortino Ratio is a modification of the Sharpe ratio. The standard deviation accounts for both positive (upside) and negative (downside) volatility; and since the Sharpe ratio uses the standard deviation as a proxy for risk, it makes no distinction between “good” and “bad” volatility.

Therefore, the Sortino Ratio fixes this issue by only focusing on the negative (downside) volatility. It uses the standard deviation of only those returns that fall under a predetermined, acceptable return target. That is why it is useful for investors to determine the rate of return needed to reach a specific financial goal. Generally, that acceptable return target is set to 0% in order to encompass all negative returns; however, investors often use whatever their MAR (minimum acceptable return) maybe—think of it as the minimum return investors will accept, their threshold.

Treynor Ratio

The Treynor Ratio, also known as the reward-to-volatility ratio, is a performance metric for determining how much excess return was generated for each unit of risk taken on by a portfolio. Excess return in this sense refers to the return earned above the return that could have been earned in a risk-free investment. Although there is no true risk-free investment, treasury bills are often used to represent the risk-free return in the Treynor ratio.

Beta

Beta is another volatility measure commonly used to compare an asset’s (or strategy’s) volatility to the risk of the broader market (systematic risk). In other words, if a specific asset or a strategy has higher swings (it is more volatile) than its broader market, its beta will be higher than 1.0; and if it moves less than its broader market, it will have a beta below 1.0. Therefore, if an asset has a beta of 1.5, it will theoretically be more volatile than its market, with higher expected returns but with higher intrinsic risks.

An asset’s broader market refers to the stock market which the asset belongs to. Generally, a market’s index is used as a proxy for the broader market (benchmark); for instance, the S&P500 Index can be used as a proxy for the US market, or the STOXX Europe 600 can represent the European market.

The beta coefficient is a statistical measure that represents the slope of the regression line plotted by inputting an asset’s returns against its market’s. It is also a component of the CAPM (Capital Asset Pricing Model), which intends to assess the return investors can expect to receive based on volatility. We will look into regression and the CAPM in future segments.

Kurtosis

Kurtosis measures the spread of the returns in a histogram. Higher kurtosis implies our returns are likely to be more extreme, as outliers (extreme returns, positive or negative) happen often.

The normal kurtosis is 3.0; so, any number higher than that indicates that our return distribution has heavier tails and vice versa (tails are the positive and negative extremes of the data, and heavier or lighter tails refers to a high or low amount of extreme returns).

From our histogram example below, we can easily find an outlier, we had one return that was between 2% and 2.5%. We found that the kurtosis in the above example is 0.85, which means that our returns are not very spread-out and there may be a low risk of seeing many extreme returns.

Skewness

Skewness represents the level of symmetry of your returns in a histogram, or more accurately, the lack of symmetry. A histogram is symmetric if it looks the same to the left and right of the center point (which is the average return).

The skewness of a normal distribution is 0; so, if we have a skewness that is higher than 0, we say that our returns are skewed to the right. This means that the right tail is longer than the left tail, and we are likely to see a few very high returns, but a lot of small losses. Conversely, having a negative skewness means that your left tail will be longer than your right, which implies that you are likely to see a few big losses, but many small gains.

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