Measuring Performance – The Key to Improvement and Assessing Strategy Risk

Measuring Performance – The Key to Improvement and Assessing Strategy Risk

J. McEldoon Strategy Portfolios 7/01/2007

Regardless of your style of investing, trading, or any other business activity for that matter, to drive continuous improvements and to assess overall performance risk of one approach over another, it is essential to track and measure what you are doing in a manner that provides you with continuous feedback and allows you to easily compare alternative methods or strategies.

In investing and trading we think of our successes as those transactions in which we make money. And yes, inevitably there will always be those ventures of ours that for one reason or another just don’t pan out and we end up taking a loss. That’s the nature of the game. But too often we don’t quantify our activities to truly gauge our long term success with one approach over another or we lack a disciplined approach in our activities to truly know if one approach is better than another. In this article I will describe a simple method that I have developed and apply weekly in my work at Strategy Portfolios for my model and client portfolios.

The Portfolio Approach

In any business or investing activity it is essential to think in terms of a portfolio as consisting of a set of activities that share a common approach or strategy all contributing to our desired set of objectives. In this portfolio approach the performance of the portfolio itself is more important than any one of the underlying activities or investments. In business and investing we often see people fail because they become too focused on one specific activity or investment and lack a common but diversified approach in their efforts that could otherwise significantly minimize the risk taken in any one activity. If you think about it, this is a lot like duck hunting with a rifle. A few very skilled marksmen might be able to do it, but for the average hunter the shotgun approach is more consistently successful. So as we take a targeted portfolio approach we are much more likely to consistently achieve our objectives over extended periods of time. For investing or trading we might accomplish this by establishing a methodology that spreads allocated investment capital across several qualified candidate issues. For example, if we are interested in small startup biotechnology companies we might elect to invest in what we consider the top 10 candidates as opposed to trying to pick out the one best candidate. If our qualification process is good the odds of selecting a future winner are much greater. Looked at another way, our risk of failure in any one issue is also greatly reduced. It’s this approach to implementing and managing any kind of investment portfolio that I’ve found separates the consistently successful from the occasionally lucky and often unsuccessful investor.

Measuring Performance

So now that we’ve established the essential importance of employing a portfolio approach, how do we go about measuring performance? Well, that depends on the type of activity you are measuring as well as the specific objectives that you have established. (Note: While the remainder of this article will focus specifically on an investment portfolio, the items discussed apply equally to any kind of business activity, product/service portfolio, etc.)

For an investment portfolio of individual stocks we might start by measuring the number of winning and losing investments or trades. For example, if you invested in 10 issues (stocks, properties, etc) and 6 of those were winners and 4 ended up being losing investments you might see these numbers of Wins and Losses expressed in a Win/Loss ratio:

Portfolio = 10 issues, 6 Win, 4 Loss

Win/Loss ratio = 6 / 4 = 1.5

You may also see these numbers expressed as a percentage of winning trades which compares the number of Wins to the total number of trades such as:

%Wins = 6 / 10 = 60%

With a Win/Loss ratio you might think that any number greater than 1.0 is good and that a %Wins figure greater than 50% is good. Well, maybe, but also maybe not.

As investors our primary objective isn’t the raw number of wins and/or losers, it’s the ‘show-me-the-money’, ‘bring home the bacon’, ‘put it in the bank’, cold hard cash that really matters. And from a business perspective we may also be interested in the amount of work involved and the expenses generated to produce these real gains. So, in addition to tracking the number of winning and losing transactions we also need to track the actual dollar amount of each winning and losing transaction. This then would provide us with another vital piece of performance information, the actual dollar amounts for the average winning and losing transaction which I refer to as the Average $Win and Average $Loss amounts.

Average $Win = total gains from all winning trades / # winners

Average $Loss = total gains from all losing trades / # losers

These numbers are important to know because they will help you drive for continuous improvement. If you strive to increase your average winning transaction amount and work to decrease your average losing transaction, your performance will obviously improve over time. One way to do this is to establish your stop loss levels on any active trade with these in mind. If you limit your next loss to something smaller than your average, your overall average then will become smaller. For a winning trade you might set a profit stop at or above your current average winning trade amount so that your average will only increase over time.

But these numbers alone are still not quite adequate. Using the numbers from our example above, let’s consider two different portfolios with different performance results. Note: both have the same Win/Loss ratio and % Wins number, but different averages from their results.

Portfolio A: Win/Loss ratio = 6/4= 1.5, % Wins = 60%

Average $Win = $1000

Average $Loss = $1200

Average $Win/Average $Loss = 1000/1200 = .83

Portfolio B: Win/Loss ratio = 6/4= 1.5, % Wins = 60%

Average $Win = $800

Average $Loss = $400

Average $Win/Average $Loss = 800/400 = 2.0

Which of these two portfolios performed better? A or B?

For Portfolio A, we had 6 wins at $1000 each for a total of $6000 and we had 4 losers at $1200 each for a total of $4800 which nets a total portfolio return of $1200.

For Portfolio B, we had 6 wins at $800 each for a total of $4800 and we had 4 losers at $400 each for a total of $1600 which nets a total portfolio return of $3200, much better than Portfolio A.

Note that I’ve included the Average $Win/Average $Loss number for each portfolio. For Portfolio A the resulting number is .83 and for Portfolio B the number is 2.0. You might think that this ratio is a good number to use to compare which portfolio is better and while it is a useful number it doesn’t adequately reflect the actual number of wins and losses.

The number we are really interested in (money in the bank) is the ratio of total gains to total losses which I will refer to as the $Win/$Loss ratio.

For Portfolio A, the numbers we are really interested in are the $6000 in gains from the 6 winners and the $4800 in losses from the 4 losers.

The $Win/$Loss ratio for Portfolio A then equals 6000/4800 = 1.25

For Portfolio B, the $Win/$Loss ratio = 4800/1600 = 3.0

These numbers can also be computed by taking the Win/Loss ratio and multiplying it by the Average $Win/Average $Loss number as follows:

Portfolio A: $Win/$Loss = 1.5 x .83 = 1.25

Portfolio B: $Win/$Loss = 1.5 x 2.0 = 3.0

The real beauty of this $Win/$Loss number is that it quantifies for you very explicitly the performance of the portfolio. For Portfolio A, a value of 1.25 tells us that for every $1 at risk and lost with Portfolio A, we’ve put $1.25 into the bank. Obviously, a number greater than 1.0 means that we have not lost any money. However, compare that 1.25 number with the $Win/$Loss number from Portfolio B. Quite a difference. With a 3.0 $Win/$Loss number we can easily see that we are gaining $3 for every $1 at risk and lost for Portfolio B.

Over time, with an accumulated track record for a portfolio, we can gain a much better perspective on the actual performance record. If we apply a consistent set of rules in implementing and managing a portfolio we can gain more confidence in the particular strategy being used and leverage that to gauge an expectation for likely future performance of the same strategy and portfolio.

To illustrate, the following are the current performance stats from the Strategy Portfolios model portfolios accumulated from over 3 years of portfolio trades (since the inception 1/2/04).

Reasonable Runaways Portfolio (6/29/07)

# Winners = 124 Average Win = $2,199.04

# Losers = 117 Average Loser = $712.09

W/L ratio = 1.06

% Wins = 51.45%

$W/$L = 3.27 Average Gain = $785.75

Here, we see the $W/$L number = 3.27 indicating that for every $1 lost, we’ve gained $3.27. Average portfolio position gain is $785.75 (includes Winners and Losers)

Overlooked Gems Portfolio (6/29/07)

# Winners = 44 Average Win = $5,667.06

# Losers = 80 Average Loser = $1,228.74

W/L ratio = .55

% Wins = 34.58%

$W/$L = 2.54 Average Gain = $1,218.16

Here, we see the $W/$L number = 2.54 indicating that for every $1 lost, we’ve gained $2.54. Average portfolio position gain is $1,218.16 (includes Winners and Losers)

Portfolio X (6/29/07)

# Winners = 49 Average Win = $14,800.42

# Losers = 72 Average Loser = $4,994.03

W/L ratio = .68

% Wins = 40.50%

$W/$L = 2.02 Average Gain = $2,923.75

Here, we see the $W/$L number = 2.02 indicating that for every $1 lost, we’ve gained $2.02. Average portfolio position gain is $2,923.75 (includes Winners and Losers)

High-Yield Income (6/29/07)

# Winners = 34 Average Win = $2,038.50

# Losers = 17 Average Loser = $676.60

W/L ratio = 2.0

% Wins = 66.67%

$W/$L = 6.03 Average Gain = $1,151.93

Here, we see the $W/$L number = 6.03 indicating that for every $1 lost, we’ve gained $6.03. Average portfolio position gain is $1,151.93 (includes Winners and Losers)

Another, very special portfolio strategy called Wealth-Builder II has even more impressive results with its combined focus on Value, Growth, and Income.

Wealth-Builder II (as of 6/22/07, historical trades from Jan 2000)

# Winners = 162 Average Win = $3,136.08

# Losers = 37 Average Loser = $1,525.60

W/L ratio = 4.38

% Wins = 81.41%

$W/$L = 9.00 Average Gain = $2,278.76

Here, we see the $W/$L number = 9.00 indicating that for every $1 lost, we’ve gained $9.00. Average portfolio position gain is $2,278.76 (includes Winners and Losers)

Measure of Risk

When we compare the $W/$L numbers for the portfolios above, we can see that they also serve as a good measure of risk associated with employing the different strategies for each portfolio. Here’s a summary view:

Reasonable Runaways: $W/$L = 3.27

Overlook Gems: $W/$L = 2.54

Portfolio X: $W/$L = 2.02

High Yield Income = $W/$L = 6.03

Wealth-Builder II = $W/$L = 9.00

Clearly, Portfolio X is the most speculative strategy while High Yield Income is a much more conservative, yet very profitable strategy. In Portfolio X we may have the highest Average Win amount of $14,800, but with a $W/$L value of 2.02 it comes with a fairly high level of risk. You can also now appreciate why I’ve given the Wealth-Builder strategy its unique name. With the combination of %Wins = 81.41% and its $W/$L = 9.0 the Wealth-Builder II strategy is not only a conservative / low risk strategy, it’s a growth engine generating $9 in the bank for every $1 risk exposure. And this is from over 7 years of data in applying this targeted portfolio approach. To add to the power of Wealth-Builder II, it only takes a couple hours per year to implement and you don’t need to be concerned with the day to day market noise. It’s truly a sleep well and grow rich strategy approach.

Hopefully, my coverage of these simple and sensible measures will inspire you to begin to track your own performance. Find out how well your methods are working (or those of your broker) and drive for improvement over time.

For additional information on Strategy Portfolios or the special Wealth-Builder II strategy and portfolio please visit:

http://www.StrategyPortfolios.com

Thanks and have a great week!

- Joel