Portfolio construction

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Portfolio construction

Measuring investment success

How to tell if your investments are doing OK?

So, once you’ve set up your lovely balanced portfolio – how can you tell if your investments are doing well?

Nowadays, most investments can be tracked easily online via your brokerage account. So you can check in anytime and see whether you’re up or down compared to when you first put your money in. (More on that in Chapter 4).

Obviously, you’d rather your pot went up rather than down, but if you look and find your stash is worth 5% more than the last time you checked, how do you know if that’s really a healthy performance? Should it be up even more? 🤔

Just like with a ’70s gameshow 📺, it’s good to check out what you could have won. In practice, that means you should always compare the return on your investments to what you could have got if you’d just kept the money in an asset with, theoretically, zero risk of losing your original stake.


The risk-free rate

Professional investors call this the “risk-free rate” – and generally use US Treasury bond as a benchmark, as – like the Lannisters in Game of Thrones – the American government’s never (yet!) failed to honour its debts.

Out of curiosity, you might also want to compare your portfolio’s performance with a broad measure of the stock market (the MSCI World Index is a good proxy of global stocks in rich countries, for example).

But keep in mind that, unless your portfolio is entirely in equities, it’s likely to rise at a slower pace than the stock market during good times – but also fall less when the economy is worse for stocks.


Balancing risk and return

As you’ve probably gathered by now, the heart of investing is balancing ⚖️ returns with risk. Imagine you lent £1,000 to a friend to invest for you. A week later, he comes back with £10,000. You’re impressed, so you ask how he did it. “I put it all on a horse at the racetrack, and it came in at 10-1 odds,” he replies. 🤯

Still impressed? The point is that it’s easier to make big gains if you’re taking big risks.

So professional investors – who hope to be investing for years to come and have reputations to uphold – obsess over their risk-adjusted returns. One commonly highlighted measure is the Sharpe ratio, which is basically returns divided by volatility (how much prices swung around).

If your investment portfolio gained 10% last year, but at one point it was down 15%, that means you had a worse Sharpe ratio than if your portfolio gained 10% and never fell more than 1% over the course of the year. 🧠

In our fourth and final chapter, we’ll talk about the practical concerns of setting up an investment portfolio.

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