difficulty is that risk is best defined at the portfolio level not at the security level. We
know that a large part of the riskiness of a security can be diversified away by holding it
in a well-designed portfolio. As we saw in the previous chapter on portfolio design,
however, investors who seek out underprices stocks may end up with poorly diversified
portfolios. To evaluate the return that they make, we must examine the riskiness of the
total portfolio.
Time Horizon for Portfolio Evaluation
Having decided to evaluate performance at the portfolio level rather than at the security
or transaction level, it remains to decide the time interval over which the evaluation is to
be done. We are often tempted to evaluate at very frequent intervals in the belief that this
will help in taking prompt remedial action. If we evaluate only once in five years, it may
be too late to do anything with the evaluation. Nevertheless, there may be strong reasons
for not evaluating a portfolio at too short an interval. Firstly, all portfolio managers have
an investment horizon. Those who have a long horizon may buy a stock on its long-term
fundamentals even if its short-term outlook is bleak. To evaluate these managers on a
short horizon is, therefore, unfair and misleading. Secondly, no portfolio manager
expects to be right all the time. He expects to make errors, but expects to be right often
enough to achieve a good return overall. Over a reasonably long horizon, his windfall
gains and losses cancel each other out and the actual return can be regarded as a
reasonable measure of his performance. But, in the short run, this is not necessarily true,
and the actual return may not be really representative. For these reasons, the time
horizon for performance evaluation should be at least two years; ideally, it should be a
little longer to include one cycle of boom and bust in the stock market.
Risk and Return
Measuring the actual return on a portfolio during a short period, say one year, is quite
straight forward. The total return equals the capital appreciation of the total portfolio
(including cash and money market instruments) plus the income and capital distributions
out of the portfolio during the period less the capital infusions into the portfolio. The
capital appreciation of the portfolio is computed by valuing the portfolio at market prices
at the beginning and end of the period and calculating the growth in value. Over a long
period of time, the return has to be computed with greater care as the timing of cash flows
cannot be ignored.
Example 1Mr. A began investing in securities on 01.01.1991 with an initial investment of Rs.25
lakhs. During the course of the year he received interest and dividends of Rs.1.5 lakhs
which he utilized for his personal expenses. In the latter part of the year, he also sold
shares worth Rs.5.0 lakhs to finance part of the cost of a house that he was building. On
31.12.1991, Mr. A finds that his shares are worth Rs.23 lakhs and that he also holds
debentures worth Rs.5.5 lakhs. What is the return earned by him during the year?