Evaluation of investment portfolio efficiency: approaches and coefficients

YEREVAN, June 3. /ARKA/. To make one’s investments profitable over a long period of time, it is important to compile a most favourable portfolio, to constantly monitor its relevance and to make adjustments to your strategy. Questions arise about how to approach the choice of assets and evaluate the effectiveness of decisions?

In this article, we will speak about the methods of analysis and their applicability in different cases.

Modern portfolio theory is based on the basic principles of Harry Markowitz, aimed at maximising the choice of assets based on the return/risk coefficient.

1. Relationship between risk and return

Investors strive to obtain the highest possible return and, at the same time, to remove both volatile and unpromising assets from their portfolio. For this purpose, it is necessary to determine the risk-return ratio.

Yield is the percentage that exceeds the value of the asset. This is the investor's earning.

For example, a share's cost is 100 conventional units (c.u.); you sold it for 150 c.u., and received 4 c.u. from dividend payments. So, the yield is (150 - 100 + 4) / 100 = 0.54, or 54%.

When comparing different assets, you need to convert the yield to annual interest: divide by the investment term in days and multiply by 365 (or 366 if the year is a leap year).

Let's go back to our example and assume that 54% of the profit was earned in 350 days. So, the return in annual percentage is 54/350 * 365 = 56.3%. The other asset earned 14% in 201 days, then: 14/201*365 = 25.4%. Accordingly, the first instrument is more efficient. Note that this is a simplified approach.

There are other, more detailed, methods described in open sources.

In modern portfolio theory, the average expected return is taken into account. It is made up of the weight of each asset multiplied by the yield.

Example:

Your portfolio consists of stocks and bonds in the proportion of 60/40. You can find out the daily yield of each security from quotations on the issuing company's website, stock exchange or thematic portals. Then you should calculate the average value for the period of interest. This way you will see the expected yield. Let's assume that this indicator for shares is 15% and 10%for bonds. So, the average expected return is 0.6 × 15 + 0.4 × 10 = 13%.

2. Correlation of instruments

One of the investor's tasks is to avoid heavy drawdowns and compensate losses from the fall of one asset by the growth of another. In order to find the optimal portfolio composition, you need to monitor correlation. This is an indicator that reflects the interrelation of assets in the time relevant to you. 

When calculating the correlation coefficient, the values are placed within the range from minus 1 to plus 1. At the greatest similarity in the dynamics of asset prices, the correlation tends to 1, when one instrument falls, the other grows to minus 1. When the correlation is minimal, the coefficient is close to zero. 

The combination of assets that are in weak dependence on each other or inverse correlation is the basis of successful diversification.

3. When forecasting, it is important to assess the risks of assets

Here we need to introduce a new term - "dispersion". It refers to a degree of risk associated with investing in a particular asset or portfolio. The variance shows how much the return of an asset can deviate from the average. The greater the variance, the higher the risk.

To summarise the intermediate conclusion: in order to select assets for your portfolio according to the principles, you need to:

- calculate the expected return of each security;

- determine the correlation;

 - calculate the standard deviation of each security;

 - assemble several options with different asset mixes;

 - estimate the expected return and riskiness (variance) of each potential portfolio;

- compare the results.

The above review allows us to draw the following conclusions:

- when compiling a portfolio and assessing its performance, one should focus on the optimal risk/profitability ratio;

- ratios differ in their applicability in different situations. The most accurate assessment can be obtained by combining approaches.

This article was prepared as part of the joint project "Year of Investing in Oneself" by ARKA, AMI Novosti-Armenia news agencies and Freedom Broker Armenia. 

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10:00 06/03/2024