Portfolio Performance

📊 Portfolio Performance: Measuring How Well Your Investments Do

The Report Card Analogy 🎒

Imagine your investments are like students in school. Just like students get report cards showing their grades, your portfolio gets a performance report card too!

But here’s the twist: Getting an “A” isn’t just about high grades. What if one student got an “A” by studying normally, and another got an “A” by staying up all night, getting sick, and feeling stressed?

The second student took MORE RISK for the same grade!

That’s exactly what we measure in portfolio performance:

• How much did you earn? (The grade)
• How bumpy was the ride? (The risk you took)
• Was the bumpy ride worth it? (Risk-adjusted return)

🎢 Standard Deviation Risk: The Roller Coaster Measure

What Is It?

Think of two roller coasters:

🎢 Roller Coaster A: Goes up 10 feet, down 10 feet, up 10 feet, down 10 feet… 🎢 Roller Coaster B: Goes up 50 feet, down 50 feet, up 50 feet, down 50 feet…

Both roller coasters end at the same place, but Roller Coaster B is MUCH scarier!

Standard Deviation tells us how scary the ride is—how much your investment bounces up and down.

Simple Definition

Standard Deviation = How much your returns jump around from the average

• Low standard deviation = Smooth, calm ride 😌
• High standard deviation = Wild, bumpy ride 🎢

Real Example

Let’s say two investments both average 10% return per year:

Investment A: Same every month. Standard Deviation = 0% (no bumps!)

Investment B: Wild swings! Standard Deviation = ~15% (very bumpy!)

The Formula (Don’t Worry, It’s Easy!)

graph TD
    A["Step 1: Find the Average Return"] --> B["Step 2: Subtract Average from Each Return"]
    B --> C["Step 3: Square Each Difference"]
    C --> D["Step 4: Find Average of Squares"]
    D --> E["Step 5: Take Square Root"]
    E --> F["📊 Standard Deviation!"]

Why It Matters

Would you rather:

• Earn 10% with no surprises? ✅
• Earn 10% but sometimes lose 20% and sometimes gain 40%? 😰

Most people prefer the calm ride! Standard deviation helps you pick.

🏆 Sharpe Ratio: The “Bang for Your Buck” Score

The Ice Cream Shop Story 🍦

Imagine two ice cream shops:

Shop A: Charges $5, gives you 3 scoops Shop B: Charges $5, gives you 1 scoop

Which is the better deal? Shop A! You get more ice cream for your money!

The Sharpe Ratio works the same way—it tells you how much extra return you get for each unit of risk you take.

Simple Definition

Sharpe Ratio = Extra return ÷ Risk taken

• Higher Sharpe Ratio = Better deal! 🎉
• Lower Sharpe Ratio = Bad deal 😞

What Counts as “Extra Return”?

Here’s the trick: We don’t count ALL your return. We only count the extra return above what you’d get from a super-safe investment (like a savings account).

Why? Because if a savings account gives you 3%, and your risky investment gives you 3%, why take the risk? You got nothing extra!

The Formula

Sharpe Ratio = (Your Return - Safe Return) ÷ Standard Deviation

Real Example

Wait! Fund A made more money (15% vs 10%), but Fund B has the higher Sharpe Ratio!

Fund B gave you more “ice cream” (return) per “dollar” (risk)!

What’s a Good Sharpe Ratio?

graph TD
    A["Sharpe Ratio"] --> B["< 1.0 = Not Great 😐"]
    A --> C["1.0 - 2.0 = Good! 👍"]
    A --> D["> 2.0 = Excellent! 🌟"]
    A --> E["> 3.0 = Amazing! 🚀"]

⚖️ Risk-Adjusted Returns: The Fair Comparison

The Running Race Story 🏃

Imagine a race:

• Runner A runs 100 meters in 12 seconds (wearing normal shoes)
• Runner B runs 100 meters in 12 seconds (wearing heavy boots)

Same time, but Runner B did something MORE impressive! They achieved the same result with a handicap.

Risk-Adjusted Returns give credit where it’s due—they adjust your returns based on how much risk you took.

Why Raw Returns Lie

Looking only at raw returns is like judging runners without knowing their shoes:

“Fund X wins!” you might say. But wait…

Fund Y might actually be the smarter choice!

How to Risk-Adjust

There are several ways, but the simplest is using the Sharpe Ratio we just learned:

graph LR
    A["Raw Return"] --> B["Subtract Safe Rate"]
    B --> C["Divide by Risk"]
    C --> D["Risk-Adjusted Return!"]

Real-Life Example

You’re choosing between two funds for your retirement:

Growth Fund:

• Return: 18%
• Standard Deviation: 25%
• Risk-free rate: 3%
• Sharpe Ratio: (18-3)/25 = 0.60

Balanced Fund:

• Return: 12%
• Standard Deviation: 10%
• Risk-free rate: 3%
• Sharpe Ratio: (12-3)/10 = 0.90

The Balanced Fund has better risk-adjusted returns!

You’re getting more return per unit of risk.

🎯 Putting It All Together

Here’s how these three measures work as a team:

graph TD
    A["📈 Look at Returns"] --> B["🎢 Measure Risk with Standard Deviation"]
    B --> C["🏆 Calculate Sharpe Ratio"]
    C --> D["⚖️ Get Risk-Adjusted Picture"]
    D --> E["✅ Make Smart Investment Choice!"]

Quick Summary

💡 Key Takeaways

1. High returns aren’t everything — A smooth 10% beats a stressful 10%

2. Standard Deviation = Bumpiness — Lower means calmer investments

3. Sharpe Ratio = Efficiency — How much extra return per unit of risk

4. Risk-Adjusted Returns = Fair Comparison — Compares apples to apples

5. Always ask: “Was the risk WORTH the return?”

🌟 Remember This!

A great investment isn’t just about making money—it’s about making money WITHOUT unnecessary stress!

Just like a good student earns A’s without pulling all-nighters, a good portfolio earns returns without wild roller coaster rides.

Now you can read any investment report card like a pro! 🎓