This post is an excerpt from Wells Fargo Investment Institute’s “Ask the Institute” series.
- Certain statistics may help evaluate how a portfolio is performing vs. a benchmark.
- Comparing a portfolio against the wrong benchmark may cause investors to take on risks that are inappropriate for their circumstances.
- Investors can monitor their portfolios regularly to ensure they are implementing the appropriate asset allocation to help them meet their investment goals.
Understanding portfolio performance statistics
Statistics are a useful way to summarize complex information in a single, convenient number. But a single risk or return number cannot convey everything investors need to know about their investments. There are many concepts (and statistics) that are important to understand when assessing portfolio performance. We would like to focus on three:
What benchmarks offer an appropriate comparison for a portfolio?
What are common mistakes investors make—like evaluating their portfolio return against a popular benchmark like the S&P 500 Index?
What metrics help investors better understanding the level of risk they are taking?
How should investors judge if the risk they are taking in their portfolios is appropriate given their investment objectives and risk tolerances?
Alignment with a plan
How can investors tell how closely aligned their current asset allocation is with potentially ideal asset allocations for their investment objectives?
Comparing apples and oranges does not work
One mistake investors can make is to measure their portfolio’s performance over a relatively short period of time against a simple benchmark, like the S&P 500 Index. For example, in the graphic below, the hypothetical diversified portfolio returned 7.4% over the 2011-2015 period. Compared to the 12.6% return of large-capitalization stocks (an asset group in the diversified portfolio) over the same period, the diversified portfolio might appear to have not done very well. However, measured against international stocks or Treasury bills, which are also in the portfolio, would make it seem that the diversified portfolio did well—even great. What’s important to remember is that none of these comparisons is truly valid because they’re comparing apples (a diversified portfolio) and oranges (a single asset class).
Performance results for the diversified portfolio are hypothetical and for illustrative purposes only. Hypothetical results do not represent actual trading, and the results achieved do no represent the experience of any individual investor. In addition, hypothetical results do not reflect the impact of any fees, expenses, or taxes applicable to an actual investment. The indices reflect the historical performance of the represented assets and assume the reinvestment of dividends and other distributions. An index is unmanaged and not available for direct investment. Hypothetical and past performance do not guarantee future results.
How to evaluate portfolio returns
Return is usually the most discussed investment metric. The financial media often report the performance of “the market” when they are actually referring to a fairly narrow slice of the market, such as U.S. large-cap stocks. Looking at “the market” from such a narrow perspective is like judging an iceberg only by its tip. There are many different “markets” that can perform quite differently under varying economic conditions. For example, many bonds perform well in a weaker environment while stocks have generally performed better when the economy is strengthening.
Source: Bloomberg 9-2-16. Equities represented by the S&P 500 Index and bonds by the Barclays U.S. Aggregate Bond Index. Quarterly data (1Q 1990-2Q 2016). Past performance is no guarantee of future results.
When evaluating portfolio performance, the measure of success or failure should depend on the investor’s personal financial goals. Consider the following questions:
- What are the investor’s goals for this investment portfolio? What is their time horizon?
- How much and what types of risk are they willing to assume for the possibility of higher return?
- Are they comfortable with the risk that accompanies a concentrated portfolio? Or would they prefer to spread the risk around?
- Why did they select this specific asset allocation? Is the reason still valid?
Then investors might ask themselves: What is the best way to evaluate a portfolio given the answer to these questions? An appropriate benchmarking strategy can help determine if the portfolio is positioned to help meet an investor’s longer-term financial goals. A portfolio may be a simple U.S. large-cap stock portfolio. If so, then the S&P 500 Index may be an appropriate benchmark. If, however, the portfolio includes some U.S. bonds in the mix to potentially help reduce volatility, then a blended benchmark that has a similar allocation to a basket of U.S. stocks and U.S. bonds may be appropriate. If the portfolio has been further diversified in an attempt to balance risk and potential return, it may include global stocks, bonds, real assets, and alternative investments. If so, a blended benchmark that includes these other types of holdings may be appropriate.
There are some additional statistics that an investor and their investment professional can use to help determine whether their portfolio is earning as much return as its level of risk suggests:
- Beta (a measure of risk): A measure of the portfolio’s sensitivity to movements in its blended benchmark when comparing portfolio against the benchmark. The beta of the blended benchmark is, by definition, 1.00. If a portfolio has a beta of 1.10, for example, it performed 10% better than its blended benchmark in up markets and 10% worse in down markets, assuming all other factors remain constant.
- Alpha: A measure of the difference between a portfolio’s actual returns and its expected performance given its level of risk (as measured by beta). It depicts a manager’s added or subtracted value by providing information about the extent of the outperformance or underperformance of active management inside a portfolio in relation to a benchmark or blended benchmark. A positive alpha figure indicates the portfolio performed better than its beta would predict. In contrast, a negative alpha indicates the portfolio’s underperformance given the expectations established by the portfolio’s beta.
- Downside risk: A broad reference to a number of specific risk metrics that focus on measuring underperformance. Downside risk helps investors understand what is the minimum return that a portfolio can outperform in 95% of the years. Risk inside the context of an investment portfolio is the chance that the expected return will not turn out as expected. In other words, in 19 out of 20 years, performance would likely be better than the figure presented, and in year 20, it would likely be worse. However, there is no guarantee that any particular 20-year period would follow this pattern.
- Downside/upside capture: A ratio that shows whether a given portfolio has outperformed—gained more or lost less than—a broad benchmark during periods of market strength and weakness, and if so, by how much.
- Standard deviation: A measure of dispersion in regard to an average. It depicts how widely a portfolio’s returns varied over a certain period of time. Standard deviation of historical performance is used to try to predict the range of returns that are most likely for a given portfolio. When a portfolio has a high standard deviation, the predicted range of performance is wide, implying greater volatility. Of course, past performance is no guarantee of future results.
Investments are subject to market risk which means that their value may fluctuate in response to general economic and market conditions, the prospects of individual companies, industry sectors, and potential risks that may be inherent to the companies’ sizes. There are no guarantees related to future performance for the security categories referred to in this commentary, be they growth, value, dividend, alternative, small capitalization, fixed income, or international securities.
For a complete list of indexes, please visit this page.
Wells Fargo Investment Institute, Inc. is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A. and other Wells Fargo & Company affiliates.
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