# Here's an insight into portfolio performance measures!

Shruti Dahiwal
/ Categories: Knowledge, Fundamental

## Evaluation of portfolio performance is a crucial step in the process of wealth creation in the long term.

Evaluation of portfolio performance is a crucial step in the process of wealth creation in the long term. By doing a periodic evaluation, an investor can assess whether his portfolio is outperforming the market or not. This way, he can take corrective measures to improve his investment decisions.

So, what are the different ways in which an investor can evaluate his portfolio performance?

A) Sharpe Ratio

Also known as the reward-to-variability ratio, sharpe ratio measures the returns achieved by the portfolio over the risk-free rate of return adjusted by the portfolio’s total risk. It can be defined as the portfolio’s risk premium divided by its risk. Sharpe ratio can be calculated using both the historical performance of the portfolio and the future expected performance. It can be used to rank the performance of different portfolios. Higher the ratio, the better.

Sharpe ratio= (Rp – RFR)/ SDp

Where,

• Rp= return of portfolio
• Rf = risk-free rate
• SDp = standard deviation of the portfolio

B) Treynor Ratio

Treynor ratio is an extension of the sharpe ratio. It calculates the returns achieved by the portfolio over the risk-free rate of return adjusted by the portfolio’s systematic risk, also called beta. Adjusting the returns by the beta gives the ratio an edge over the sharpe ratio as it is the systematic risk that is priced, not the total risk. Just like sharpe ratio, the treynor ratio can be calculated using both the historical performance of the portfolio and the future expected performance. This ratio can be used for ranking the performance of the portfolios. Higher the ratio, the better the risk-adjusted returns of the portfolio.

Treynor ratio= (Rp – RFR)/ Beta

Where,

• Rp= return of portfolio
• Rf = risk-free rate
• Beta= Systematic risk of the portfolio

C) Jensen’s Alpha

Like the Treynor ratio, Jensen’s alpha makes use of systematic risk. It calculates the risk-adjusted return of the portfolio using the beta of the portfolio and the capital asset pricing model (CAPM) relative to the market portfolio.

αp = Rp – {Rf + βp[E(Rm)– Rf]}

Where,

• αp = Alpha of the portfolio
• Rp= return of portfolio
• Rf = risk-free rate
• Beta= Systematic risk of the portfolio
• E(Rm)= Expected market returns

The sign of αp indicates whether the portfolio has outperformed the market. A positive αp indicates that the portfolio has outperformed the market whereas a negative αp indicates that the portfolio has underperformed the market.

With the above-mentioned measures, an investor can evaluate his portfolio’s previous performance. This information can help him determine the performance he expects in the future.

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