To determine the best portfolio for an investor, usually several characteristics are used: return on investment, return on portfolio, return on risk, and return on effort. Let’s looks at these while looking at three different example investors:
Investor A: this investor is not quite a day trader but more like a “month” trader. He actively manages his portfolio every week by rebalancing, researching stocks and other investments, and manages to beat the market by 50%.
Investor B: this investor is barely an investor at all. He puts his money in CDs and creates several CD ladders. This is rather automatic every month and he manages to beat the market by a marginal percentage.
Investor C: this investor has a formula or just a couple of funds/stocks that he invests into throughout the year. He rebalances the allocation only twice a year towards his optimum ratio.
These three investors are all doing well and all have strengths and weaknesses into their investing technique. You can probably find plenty of styles on how to invest elsewhere, but how to gauge between them, this is where it might be challenging.
Return on Investment
Return on Investment is the return the Investor actually received for his money.Â It is a money-weighted return by taking into account the timing of the withdrawals and contributions to the account.Â It can be calculated using the XIRR function in Microsoft Excel.Â It especially calculates the Return on Portfolio between each investment event (withdrawal or contribution) and adds them together with respect to time duration.
Return on Portfolio
Return on Portfolio is the return the portfolio generates.Â It is a time-weighted return and does not take into account the timing of the withdrawals and contributions.Â It acts as if the contributions and withdrawals happened at the very beginning of the investment time period.Â This return is usually graphed as “Return on $10,000” plots.
Return on Risk
When comparing a portfolio, the return on risk is also important. An investor should try to minimize risk while maximizing gains. If an investor had a portfolio consisting of just municipal or government bonds yielding 5% per year and a portfolio made up of highly volatile and risky tech stocks also yielding 5% per yield, the “better” portfolio would be the one with the municipal one. He is risking less, but gaining the same.
Unfortunately, most portfolios are not so simple. The investor might have to assign an point value to the risk of the portfolio or investment type and develop a weighted “risk” return. I would suggest a scale of 1-5 when determining risk: 1 would respond to a safe investment that is insured against like CDs and money market accounts. 2 would respond to municipal or US government bonds. 3 would be corporate bonds. 4 would be index funds, ETFs, or mutual funds. And 5 would be individual stocks. Of course, there are grey areas and exceptions, such as high risk ETFs, so please feel free to adjust or create your own risk scoring technique.
Return on Effort
When judging portfolio techniques, a portfolio that doubles throughout a year, but requires daily maintenance is not necessarily the best portfolio. You have to consider the amount of time and effort that the investor puts into the portfolio and compare that with the gains. Portfolio research and maintenance should be accounted for.