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12.10.15

How Risky is Your Portfolio? Using Metrics to Quantify It
David M. Bowman

How has your portfolio performed this year? It is a simple enough question that is actually not so simple. That is because a portfolio’s return over the short term provides little insight into whether the result was achieved through good decision making or despite it.

In fact, to fully understand your results, you need to consider your investments’ performance on a risk-adjusted basis. Luckily, various statistical measures are available to make it easier to see how much risk a manager has assumed to generate a certain level of return.

Risk Metrics

The following are common risk metrics that help investors better understand how their portfolio is positioned:

Beta
Beta measures how sensitive an investment is compared with the overall market (usually represented by the S&P 500 index). A fund or portfolio with a beta of 1.0, for example, would have the same level of volatility as the market as a whole. Investments with a beta of less than 1.0 would be less volatile than the market, while investments with a beta of greater than 1.0 would have displayed increased volatility.

If most of your investments have a beta higher than 1.0, you can expect more volatility in your asset values. That may be appropriate if you are investing for long-term goals and have a high risk tolerance, but less so if you are nearing retirement or have little appetite for market fluctuations.

Alpha
Alpha measures how an investment or an overall portfolio performed relative to a benchmark. A portfolio with an alpha of 2.0 would have outperformed its benchmark by two percentage points, while an alpha of -2.0 would have underperformed to the same degree.

This metric reveals how the manager did versus how well the manager was expected to perform. In other words, alpha measures the amount of value a manager provides.

Sharpe Ratio
The Sharpe ratio, which is named for its creator, Nobel laureate William Sharpe, provides a straightforward way to make apples-to-apples comparisons of investments’ risk-adjusted performance. The calculations are complicated, but it is enough here to note that the higher the Sharpe ratio, the better.

For example, consider two funds, each returning 25% total over a period of three years. If the first fund’s Sharpe ratio is 1.0 and the second fund’s Sharpe ratio is 0.7, you will know that the first investment was able to achieve the same performance while taking on less risk.

R-squared
This metric indicates how closely an investment correlates with its benchmark (typically the S&P 500 for equities and the Treasury Bill for bonds). It is measured on a 100-point scale, with 100 indicating an investment perfectly in sync with the market, and 1 indicating virtually no relationship.

This metric can help you determine how diversified your portfolio is. It also can help you understand the effectiveness of beta when applied to your investments. If, for example, your portfolio has a low R-squared, beta probably will not provide you with as useful risk information.

Looking Ahead

These statistical measures of risk and reward are useful tools for portfolio analysis. However, keep in mind that they only look at past performance and do not necessarily tell you anything about how your investments will perform in the future, or whether your portfolio managers will continue following their existing approach. However, they can help you evaluate a managers’ past decisions and to choose among various investment options.

All things equal, investors want to capture the highest possible returns with the least possible risk.

If you need assistance analyzing your portfolio’s performance or need a referral to a qualified investment advisor, contact David Bowman at dbowman@orba.com or call him at 312.670.7444. Visit ORBA.com to learn more about our Wealth Management Group.

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