Investing is the tool, not the goal
Question: How do I effectively measure my investment performance? Asked at “Ask a Friend, Ask Efren” free service at www.personalfinance.ph, SMS, Viber, Twitter, LinkedIn, WhatsApp, Instagram and Facebook
Answer: There are many ways to measure investment performance. To start with, you can compute for your investment portfolio’s return. Notice I said portfolio as risk management through diversification is equally important. So first, the convention in return measurement is to use compounded annual growth rate, otherwise known as annualized or effective annual return, as the method when measuring performance over periods longer than one year.
At the risk of causing you to be nauseated, the formula is to divide the current value by the base value, raise the answer by 1 over the number of years covered, subtract the number 1 and convert the answer to percentage form.
If you were looking at performance over a period equal to or less than one year, absolute return would be sufficient. The formula is to divide the current value by the base value, subtract the number 1 and convert the answer to percent form.
But what we have done is to compute return without taking into consideration risk. Getting to a certain destination for example may have taken just a short period. But at what speed through busy streets were you traveling, all the while taking risks in possibly violating traffic regulations and even courting accidents?
Three measures for computing risk-adjusted returns are Sharpe ratio, Treynor ratio and Jensen’s Alpha. Just Google the definitions and formulas for the three as we do not have the space to tackle them here. Suffice to say that risk-adjusted returns give the investor a better handle on the return he earned for each “unit” of risk that he took.
Now, are we done? Let’s take some advice from the brother-sister duo, the Carpenters to literally build on effectively measuring performance. Know that we’ve only just begun. Now, let’s focus on you.
Sometimes, not often enough, investors fixate on returns. Inside their head, wheels are turning and sometimes they’re not so wise. Think of investments as clothes. You may buy them off the rack. But you will see that there will be no perfect fit. Sleeves may be too short or the hemline too high. The fabric may be itchy or the color too fancy. Make it easy on yourself and have your clothes tailor-fit for you.
In investing, you need to first quantify your future goals then derive the investment return you need to earn given the amount of money you have to start with and what you can periodically add, which return will be tempered by the risks you are willing to take. Only then can you go looking for investments that match your return and risk preference. Patience is key to your success. There are so many roads to choose so start out walking and then learn to run.
You can opt to either have your money managed for you through pooled funds and investment management accounts or to invest directly. Do remember that in investing directly, you will need Sizeable funds, Expertise/Experience in investing, Time available for managing. In other words, you need to be all SET. Following these simple rules is the only way for you to feel on top of the world, looking down on your portfolio creation.
Unfortunately, some investors just walk on by without paying attention to the best practices in putting money to work. In this regard, my fearful forecast is that these people will lose money in investing if they continue to: chase after returns without considering why they are investing in the first place and without considering the pertinent risks; be overconfident with their abilities to invest directly; just listen to [free] tips and act on them immediately; not diversify their holdings; be obsessive-compulsive and go crazy with monitoring their performance daily.
If you invest correctly, you will find a place where there’s room to grow. And yes, you’ve just begun. INQ
