Jul 21, 2007

Importance of consistent portfolio performance

Continuing the thoughts of portfolio management from an earlier posting on Position Sizing ..

When the SP500 wave is rising upwards, it not very tough to make a few stock picks that can make some decent profit. If you are good at stock picking then you might even make big money during that bull market. But if you are investing or trading for a longer term, like for retirement or for children's school, then the bottom line is to make sure that your entire portfolio did well at the end of a longer term, say 10 years. Agree?

Making good profit one year and losing another year will not yield better performance in the long term. Let us consider an example to make this point clear. Let us say Bob started his portfolio ten years back with an initial amount of $100,000. Let us say his hypothetical performance for the past 10 years has been the following:































































Year Return % Account Balance
199716%116,000
199812%129,920
199951%196,179
2000-8%180,485
2001-28%129,949
2002-26%96,162
200315%110,587
20048%119,434
20059%130,183
200612%145,805
Average
6%











Notice that Bob's performance had variations in his returns ranging as high as 51% in one year and as low as -28% in another year. Bob's final account balance was $145,805 and his average return for the 10 years was 6%.

Let us hypothetically say that Bob was able to deliver the same average percentage of 6% from previous example every year. Then his portfolio performance would have been the following.































































Year Return % Account Balance
19976%106,000
19986%112,360
19996%119,102
20006%126,248
20016%133,823
20026%141,852
20036%150,363
20046%159,385
20056%168,948
20066%179,085
Average
6%











The difference at the end of 10 years was: 179,085 - 145,805 = $33, 280.

The example above made two points clear and they are:

  1. Measure your portfolio performance frequently, once a quarter or at least once a year. (But not as frequently as daily or weekly).
  2. When you measure the performance as mentioned in step 1, make sure your portfolio is consistently performing high.

So one of the goals of your portfolio management should be to achieve consistently high returns as much as possible. Some of the techniques you can use to keep the performance consistent are Diversification, maintaining appropriate Sharpe Ratio and Reward-to-Risk ratio.

-Nidhi