With the Sensex touching new highs, the most common question on the mind of investors is how their equity portfolio is performing. Often, investors simply define a successful portfolio by a positive return on investment, ignoring the risk factor.
Investors need to classify their portfolios into similar risk classes based on a measure of risk and, then, compare the rates of return for alternative portfolios directly within these risk classes. Here are four major composite equity portfolio performance measures that combine risk and return performance into a single value.
Peer group comparison
This is the most common manner of evaluating portfolio. This is computed by calculating a portfolio’s relative return ranking compared to a collection of similar funds or portfolios. The major advantage of a peer group comparison is that it is relatively simple to compute. The objective here is to compare the returns generated by a given portfolio relative to other portfolios, which follow more or less a similar mandate. This comparison can be captured easily through a boxplot graph. Though it is simple and easy to compute, it is often difficult to find a peer group and the assumption of peer portfolios following a similar mandate is a doubtful one.
Treynor Portfolio Performance measure
Treynor developed the first composite measure of portfolio performance that included risk. He postulated two components of risks, namely risk produced by general market fluctuations and that resulting from unique fluctuations in portfolio securities. To identify risk due to market fluctuations, he introduced the concept of beta, which defines the relationship between the rates of return for a portfolio over time and the rates of return for an appropriate market portfolio. A higher beta indicates the portfolio that is more sensitive to market returns and has greater market risk and vice versa.
In a completely diversified portfolio, these unique risks for individual stocks should cancel out. As the correlation of the portfolio with the market increases, unique risk declines and diversification improves. Treynor ratio exhibits the risk-adjusted performance of the portfolio or fund. His formula goes as follows: (Portfolio Return – Risk Free Rate of Return )/Beta.