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Tag: how to invest

Measuring performance, risk / reward associated with an investment / portfolio

how to invest

tracking performance of an investment

Before you make an investment, besides other things, you must also measure the performance and risk / reward associated with it. For example, if your investment is giving higher returns, but is too volatile and is not in tune with objective of your investments, than you must stay away from it because of the risk associated with such investments.

There are many factors to keep in mind, but lets start with some statistical indicators. Some of the standard  tools to measure risk associated with investments such as mutual funds and stocks, form part of Modern Portfolio Theory. These include standard deviation, r-squared, alpha, beta, and Sharpe ratios. These ratios help us measure the historical behavior of investment risk and volatility.

1.. Standard Deviation

“High standard deviation denotes high volatility”.

Standard deviation is applied to the annual rate of return of an investment to measure its volatility (risk). It measures the dispersion of data from its mean. In simple words, the more that data is spread apart, the higher the difference is from the norm. It lets you understand that based on its historical performance, how much the return on an instrument is deviating from the expected returns.

2.. R-Squared

Another statistical measure that represents the percentage of a fund portfolio’s and can be explained by movements in a benchmark index is known as R-squared. Its values range from 0 to 100. A mutual fund / stock with an R-squared value between 85 and 100 denotes that the performance of the fund is closely correlated with that of the benchmark index (of same class). And performance of an instrument that has a rating of 70 or less is less correlated with that of benchmark index.

However higher the R square in case of mutual fund, means either the fund is an index fund or is close to being the index fund. These let you take a decision on whether you invest in a ETF or another diversified fund, depending on your objective of investment.

3.. Alpha

Another tool to judge performance of a fund / portfolio is to measure its “Alpha”.

Alpha measures performance on a risk-adjusted basis. Alpha ratio takes the price risk (volatility) of a mutual fund / portfolio and compares its risk-adjusted performance to a given benchmark index. The return an investment generates in excess of the investment relative to the return of the benchmark index is its “alpha.”

In other words, more the alpha, the better it is. A positive alpha of 1 means the investment has outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha would indicate an under performance of 1%.

4.. Beta

Beta measures the systematic risk / volatility of a portfolio in comparison to the market as a whole. Beta denotes how a fund , stock or portfolio performance would swing in response to any swing in the market. By definition, the market has a beta of 1.0.

A beta of 1.0 indicates that the investment’s price will move exactly in accordance with the behavior of market. A beta of more than 1.0 indicates that the investment will be more volatile than the market. Thus, if a fund portfolio’s / stock beta is 1.2, it is said to be 20% more volatile than the market. Similarly, a beta of less than 1.0 indicates that the investment’s price will be less volatile than the market. If you want to play safe, not take much risk and is looking more to preserve capital, you must focus on fund portfolios with low beta. Similarly if you are an aggressive investor and foresee market performing well in coming times, you must invest in portfolio with a high beta.

5.. Sharpe Ratio

Last, but not the least is “Sharpe ratio” — another important way to measure performance of a fund / portfolio.

The Sharpe ratio tells investors whether an investment’s returns are due to result of excess risk taken by the fund manager or is it because of the smart decisions taken to manage the fund.

This measurement is very useful because although one portfolio can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The higher the Sharpe ratio of a portfolio, the better its risk adjusted performance.

There are some other measures also to evaluate performance, risk/reward associated with an investment. Do keep in mind that the ratios may mislead you if other parameters are also not considered.

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Know what type of investor are you

Are you a successful investor or are the one who is being hit like a shuttle cock every now and then by the market as well as the friendly broker or advisor, or are the one who is sitting on the fence hoping to find the “golden ticket” to success.

Chances are either you are sitting on the fence or are unhappy with your investments, while your agent and broker are making money at the cost of your investments.

You might also have the following typical characteristics and behavior associated with investing:

The Ignorant

You are the key to survive for your Relationship manager and agent. The moment your agent and relationship manager has to fulfill his branch target or win a trip to Bangkok, he / she start “planning” on how to take out some business from you. Mind you the “Planning” is on how to take money out of you in the guise of “Planning” an investment for you.

He will talk big of Indian GDP growth, and then how you can make a killing in investing into infrastructure funds. One day he will talk about the land bank of one big builder and then another day on why is it safe to invest in Gold only. Then he will also convince you easily that one particular unit linked plan is the best in the market and it will double your money in the shortest possible time.

And you fall prey to all this. He will take out the form, get your signatures and fill it later. Because if he spends a lot of time filling up the form in front of you, there is a possibility of you changing your mind.

The Speculator

If you are a speculator, you want to make much higher returns and knowingly or unknowingly take extra risks of not diversifying their portfolio in various asset class or invest in few within the same asset class. You tend to choose taking control of your investments. You generally get a hot stock tip from your friend, broker or the business channel, and try to cash on it.

You are not scared to throw some money in Futures and Options, or are ready to buy a flat from a builder in a suburb without even investigating it enough. For you its all about now to take a chance on getting rich.

You are more of a gambler and doesn’t always invest smart. While sometimes you are lucky in winning lottery, you can never expect it to win every time.

The Spectator

You are the investor who is always busy in something and have no time to look at your investments. You will find a million answers on not investing. Stock market to you look risky. And by the time you take a decision on investing in a particular stock or mutual fund, it looks like market is headed for a crash. You have no knowledge in the real estate sector and no time to visit a site either. You cannot park your funds in Fixed deposits because what if you might need your funds tomorrow. And the investments you have made, if any under pressure of your friend, you have no time to review it or look at its performance.

Is it because you fear loosing your money or have no knowledge on where to start ? You are likely to make some money with your investments and not loose any money. But if you keep delaying the investments to tomorrow, you certainly are going to loose the value of cash in your hand (inflation is at an average of 8%) and also delay in accomplishing your goal of having a bigger / better house or car.

The Know all

You know everything. Yes ! This is what you believe !! You are the one who flips through Economic times quiet often. Enjoy watching Business Channels. And remembers that once the analyst had recommended a particular company to buy insurance. Or that Mid cap segment had a good run in a particular year.

But what about now. Has the micro and macro scenario changed. While you are now going for that particular insurance product, have you studied that IRDA (You know IRDA right!!) has brought in new regulatory changes and that product is no longer the best any more. Or that a large cap fund will deliver better returns in a particular cycle of market volatility.

The chances are that you were busy more in your work (in which you are good, probably best) and missed out on the other changes in the micro and macro environment. While having a discussion with your colleague or friend it is ok to show off that you know all but you can you risk taking major investment decisions for your self ?

The Saver

You are busy saving your hard earned money. You are likely to have a PPF account, some Bank FD’s, Mutual Funds, NSC’s and some Insurance policies. You are the one who will buy “Everything” that comes to you. It all started with saving taxes. Now it is more of a habit as you have spare money. Your portfolio might have everything, but most are impulsive decisions to invest rather than a clear , well thought of strategy to make your money optimally diversified and careful study of competitive products. You also are less likely to review your portfolio at a regular interval.

In our opinion most successful investors go through stages of investing before they become successful. Some take a longer and painful journey, while others are lucky to hit growth faster. And some learn from others mistake.

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