Portfolio Performance

Photograph:  Dome of Blue Mosque in Istanbul, Turkey

If you hear someone come across a bit strong when it comes to portfolio performance, ask a few simple straight-forward questions.

1.  How is the performance measured and does it meet AIMR standards?  Professionals will know AIMR stands for Association for Investment Management and Research.  ITA Wealth Management readers know performance as the Internal Rate of Return (IRR) since we are calculating one portfolio at a time and we are not comparing portfolios.

2.  How is portfolio uncertainty or volatility measured?  One expects better performance from high volatile portfolios.  We also expect high volatile portfolios to do worse in bear markets.

3.  What is the Return/Uncertainty ratio for the portfolio and is uncertainty measured using mean-variance or semi-variance?  Once more, ITA Wealth Management readers understand what is going on with the Sortino and Retirement Ratio calculations.  At least those experienced with the TLH spreadsheet understand the importance of using semi-variance where the money manager is only penalized when the portfolio under performs the benchmark.

4. Mention of benchmark brings to mind the fourth question.  What benchmark is used as a portfolio standard?  How is an appropriate benchmark defined and what are the requirements?

While the TLH spreadsheet seeks to answer the above questions, it is not a perfect tool.  Despite our best efforts, there remains some "splinters" in the calculations and I've pointed them out in past blog posts.  When I spot new issues, I will bring them to readers attention.  If there is one thing that is needed in the world of investing it is honesty.  Rather than cover up inherent performance problems we seek to uncover them and make corrections when possible.

Eight Asset Porfolio

Photograph: When I first walked Devastation Trail in late 1961 or early 1962, there was no vegetation to be seen as it was soon after the eruption.

Consider the following portfolio that holds eight assets including cash.  In this analysis, I am using the 20-year treasury ETF, TLT, to represent cash, a substitution that gives the portfolio a slight boost over current money market rates.  The portfolio holds 22% in two actively managed funds, 63% in four ETFs, 9% in a stock, and the remainder in cash.  When applying a QPP analysis to this portfolio, what are the results?  Check out the slide below for the analysis.

In the following analysis, I am assuming the S&P 500 will return 7% a year and the uncertainty or volatility will approximate 15%.  The actual performance of the portfolio is projected to lag the S&P 500 by one percentage point and the projected uncertainty is much lower (a positive) than what we expect from the S&P.

Scrolling down the page we note the Diversification Metric is 11% points below our stated goal of 40%.  The Portfolio Autocorrelation (PA) indicates this portfolio will have wider price swings than we prefer.  We want PA to be as low as possible.

Would any reader care to posit what the weakest link is in this portfolio?  With a few changes we should be able to strengthen the projected outcomes.

The Return/Uncertainty Ratio

Formerly, the title of this post would have been the Return/Risk Ratio.  However, Risk carries many meanings so I am switching to Uncertainty to describe portfolio volatility.  The whole notion of Return/Uncertainty is at the forefront of my thinking today since this is the end of the first quarter for 2011.  Platinum members using the TLH spreadsheet will need to update the SR worksheet after all the data is in late this afternoon so the semi-variance uncertainty calculation is current.

There will be a slight error in the calculation since the portfolios will not include all the first quarter dividends.  In the big scheme of things this will not make all that much difference, so go ahead and record the most accurate IRR data for both the portfolio and the benchmark you are using for your portfolio.

"You can't manage what you don't measure."

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Solving Investment Problem #5: It is too late to start saving.

Balderdash!  It is never too late to begin saving for retirement.  Yes, it is preferred to follow "The Golden Rule of Investing" and start saving as early as possible, but it is never to late to begin.  Let me illustrate with a short story.

I know of one family that had almost no savings by age 57.  The house was paid in full, but savings for retirement were close to nil.  A friend of this family suggested they begin saving and putting money away in the stock market.  Several mutual funds were identified – not the best recommendation.  Nevertheless, disciplined month after month saving allowed this family to build a nest egg of $700,000 over the next 30 years.  Frugal living, long life, and disciplined saving were the key factors in building this retirement portfolio.  It was not astute investing.

While I do not recommend readers putting off saving for retirement till age 57, don't take the attitude it is too late to begin saving.  Get started today or when your next paycheck arrives.