How Well Did Your Portfolio Really Do In 2021?

How Well Did Your Portfolio Really Do In 2021?
Stéphane Renevier, CFA

about 2 years ago5 mins

  • If you want to assess how you really performed in 2021, it’s important you spend time understanding what really drove your returns.

  • You should compare your returns to the level of risks you took, which you can do via the Sharpe ratio or the MAR ratio.

  • To really assess your “active” performance, you should define a clear passive benchmark and objectively look at how you did relative to that benchmark.

If you want to assess how you really performed in 2021, it’s important you spend time understanding what really drove your returns.

You should compare your returns to the level of risks you took, which you can do via the Sharpe ratio or the MAR ratio.

To really assess your “active” performance, you should define a clear passive benchmark and objectively look at how you did relative to that benchmark.

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We’ve just about scraped through another year, which makes now the perfect moment to look back on everything you’ve achieved. The best investors, after all, take stock of what they got right, where they went wrong, and how to hit the ground running in the new year. But it takes a critical mindset to evaluate your performance, so here are the three questions you need to ask yourself to work out how well you’ve really done…

Where did your returns come from?

The more clear-sighted you can be about what drove your returns, the better. Did they, for example, all come from a concentrated bet in one stock that performed exceptionally well? Or did you have a mix of asset classes that balanced each other out?

Start by calculating the return contribution of each asset, sector, and asset class to your overall portfolio returns (I’d rather not get too in the weeds about how to calculate these metrics in this Insight, but there are plenty of YouTube videos out there you can refer to). As a general rule, the more diversified your returns, the better. Making money from concentrated bets is only a good sign if you can do it again in 2022, and 2023, and so on. So try to answer as objectively as possible whether you got lucky this year, and whether you think you can repeat it next year.

Just remember: being wrong for the right reasons is generally better for your long-term performance than being right for the wrong reasons.

How did you perform on a risk-adjusted basis?

Successful investing is all about generating the highest return relative to the risks you take.

A measure of risk like volatility is a good place to start: sure, it has its drawbacks (it doesn’t differentiate between positive and negative returns, for example), but it does provide a good indication of how risky your portfolio is. The higher the volatility, the more you can expect your portfolio to vary in a typical year. That’s obviously great when it goes well, but not so great when it doesn’t.

If you want to know how your returns compare to the risks you take, two metrics could be useful. The first is the Sharpe ratio, which calculates how much of a return (in excess of the risk-free rate) you generated per unit of volatility. The second is the MAR ratio – the return you’ve realized divided by your maximum drawdown (the biggest loss you’ve experienced).

You could also adjust that metric and use the average of your worst three losses as the denominator, to avoid relying too much on just the largest one.

Let’s use three very different investors as an example: Alin, who went all in with 70% of her portfolio invested in Tesla’s stock and 30% in Virgin Galactic; Valu, who invested in high-yielding value stocks; and Karen, who held a traditional portfolio of 60% stocks and 40% bonds. Alin would’ve finished the year with the highest return at 34%, followed by Valu at 22%, and Karen at 6%.

Returns and key metrics. Source: portfoliovisualizer.com
Returns and key metrics. Source: portfoliovisualizer.com

Alin’s portfolio was unsurprisingly the riskiest with a volatility of 57%. Such volatility means that you’d expect her portfolio to vary by + or -57% in a typical year. So to say she performed well, we’d need to see very high returns given the level of risks she takes. In comparison, Karen had the least volatile portfolio at 6%, so her threshold for success is lower. Looking at Sharpe ratios, we see that Alin’s was half that of Valu. So while Alin’s returns were 4x higher, she took 10x more risk. Looking at this from a risk-adjusted perspective, Valu did much better than Alin.

Drawdowns. Source: portfoliovisualizer.com
Drawdowns. Source: portfoliovisualizer.com

As for the MAR ratio, Alin experienced a maximum drawdown of 27%, Valu of 6%, and Karen of 2.5%. By adjusting their returns for their maximum losses, we see that Valu and Karen (MAR of 3.7) actually performed much better than Alin (MAR of 1.4).

So who performed best overall? While Valu and Karen generated lower returns than Alin, they’ve both achieved higher risk-adjusted returns. Relative to the amount of risk they took, we can arguably say they performed better. However, none of them managed to beat the S&P 500, which for 2021 generated the highest risk-adjusted returns of all.

Of course there are other measures of risk-adjusted returns available, like the Sortino ratio, the Gain-to-Pain ratio, or the Return Retracement ratio. There’s no perfect metric, and each has its advantages and disadvantages. It’s also important to remember that the future might be very different from the past. What matters most is that you understand how your returns compare to the risks you took.

How did you perform relative to benchmarks?

If you’re an active investor, having a benchmark by which you can measure performance is key.

By benchmark, I’m not just talking about using the S&P 500 like most mutual funds do: I’m talking about finding the most accurate “passive” expression of your strategy. If you’re a value investor for example, a value ETF might be a fair benchmark. After all, if you can’t outperform the cheaper and simpler passive version of your strategy, you’d be better off investing in that same ETF.

To assess your performance against the benchmark, you should first look at the alpha and beta of your portfolio versus your benchmark. Your beta indicates how much risk you took relative to the benchmark, and your alpha captures your real “skill” – the part of your returns that can’t be explained by taking higher risk. A high alpha is the reason hedge fund managers are so well paid: they can (in theory at least) produce returns that don’t depend on the general market direction, or on taking higher risk.

You should also understand why you deviate from your benchmark. If you outperform, is it because you have an edge in selecting the best assets, or is it because you manage your risk better? Likewise, if you underperform, is it because you’re striking the wrong balance with your portfolio? You should form hypotheses but also test them, in a quantifiable way if possible.

This approach works for all the metrics we’ve seen: the more time you spend understanding what these quantitative metrics are telling you, the more you’ll learn about the strengths and weaknesses of your approach, and the more you’ll be able to improve your process. And since 2022 might prove a very different year than 2021, that’s more important than ever…

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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