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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