Step 12
Level: beginner
Volatility measures the volatility of returns, while standard deviation is a popular measure to quantify that volatility. If measured incorrectly, investors can easily reward lucky decisions and punish correct decisions but encounter an unfavorable environment.
High volatility does not always mean the risk of permanent capital loss, but it strongly affects psychology, sizing, drawdown and the ability to maintain strategies. Standard deviation is useful when returns have a relatively stable distribution, but may underestimate tail risk and rare shocks. A single return number is not enough to conclude whether a strategy is good or bad.
By knowing where the returns came from, what risks were taken, and whether the results exceeded the benchmark, investors can improve the process instead of just reacting to the final result.
Volatility measures the volatility of returns, while standard deviation is a popular measure to quantify that volatility.
Measuring performance is not just about showing off results. The goal is to understand whether the strategy worked as expected, whether the risk was worth it, and whether the results came from skill, environment, or luck. A portfolio with high returns but too much risk may not be as good as a more stable portfolio with lower returns and suitable for your goals.
High volatility does not always mean the risk of permanent capital loss, but it strongly affects psychology, sizing, drawdown and the ability to maintain strategies. Standard deviation is useful when returns have a relatively stable distribution, but may underestimate tail risk and rare shocks.
A performance metric always has a range of uses. CAGR does not indicate drawdown. Sharpe does not see all tail risks. The wrong benchmark leads to wrong conclusions. Attribution requires sufficiently good data. So use multiple complementary metrics instead of finding a single number to represent the entire quality of an investment.
Read volatility as a measure of the bumpy ride, not the sole definition of risk.
During each review period, record the absolute return, return relative to the benchmark, drawdown, volatility and main drivers of performance. This helps you distinguish strategic issues from short-term noise, and detect early when the portfolio deviates from its original goals.
Choose only low volatility assets without checking for liquidity risk, leverage or loss of purchasing power.
A common mistake is to measure results in the way that is most favorable to the story you want to believe. Serious investors need to accept consistent metrics, appropriate benchmarks, and long enough data. Good measurement does not make the results better, but it makes the lessons clearer.
The fluctuation of returns or prices over a period of time.
A statistical measure of how much returns deviate from the average.
Risks from rare events that cause great damage.
There are measures of absolute returns, risk-adjusted returns, benchmark-relative returns, drawdowns, and return attribution.
Some metrics are used to compare strategies, some are used to understand investor experience, some are used to check risk.
Performance metrics depend on data quality, measurement period length, and benchmark suitability.
Application in performance measurement
The two portfolios have a 10 percent CAGR, but a portfolio that fluctuates 25 percent per year will be much more uncomfortable than a portfolio that fluctuates 8 percent.
Risk performance analysis
Choose only low volatility assets without checking for liquidity risk, leverage or loss of purchasing power. This causes investors to draw the wrong lesson and can increase risks in the next cycle.
Changing the start or end date for better results compromises the integrity of the review.
Inappropriate benchmarking makes a portfolio appear better or worse than it actually is.
Choose only low volatility assets without checking for liquidity risk, leverage or loss of purchasing power. Returns are only meaningful when accompanied by volatility, drawdown, liquidity and targets.
Exercise 1 - reflection
Get portfolio results for the most recent 12 months and analyze them from the perspective of volatility & standard deviation.
Exercise 2 - case_study
The two portfolios have a 10 percent CAGR, but a portfolio that fluctuates 25 percent per year will be much more uncomfortable than a portfolio that fluctuates 8 percent. Identify the correct conclusion, the likely wrong conclusion, and the additional data needed.
Exercise 3 - action_plan
Create a performance review sheet of 5 metrics you will track each quarter.