- Should you actively manage your own assets?
- Use objective criteria to measure your success...or lack of it.
- Compare Alpha on your portfolio to Alpha on alternative portfolios you'd consider.
Like many readers on this website, I'm an individual investor. What this means is that I have to wear two hats. Foremost, I am a business owner, and it's my responsibility to maximize my returns, minimize my risks and to run this business by consuming as little time and money as possible. At the same time, I'm also an employee of my own business, which means I have to constantly compete against other candidates for my position, and that I should keep an eye open for better employment opportunities. If I want my investment business to be anything more than a fun hobby, I have to be willing to fire myself, I have to give myself periodic performance reviews, I have to be willing to quit, and I need a consistent and measurable method for making all of those decisions. The number one criterion I use is my portfolio "Delta."
The steps for measuring my portfolio Delta proceed like this. First, as a business owner, I have to ask myself is "if I fired my investment manager, what or who is my next best alternative?" This is a subjective question based entirely on my personal risk tolerance and my own philosophical beliefs about investing. Call it "owner's prerogative." In my case, I am comfortable with average investment performance and with taking average risk, provided that doing so is cheap and requires little time and effort on my part. From what I know of myself, I am entirely certain that I would be comfortable with investing 70% of my portfolio in the Vanguard Total World Index (NYSEARCA:VT) and the Vanguard Total Bond Market Index (NYSEARCA:BND), or a portfolio that looks pretty similar to that, and sticking with it for life. Other business owners would certainly pick a different "next best alternative" investment portfolio, but my job is to just ask what I would actually do if I fired myself.
Next, I have to ask whether the investment manager I work with has delivered risk-adjusted net returns that at least equal those on my next best alternative portfolio. If not, then I need to fire my investment manager, and I don't care whether my investment manager happens to be me, or anyone else.
To figure that out, I first derive the Beta of my portfolio. For example, suppose my total portfolio consists of $100,000 worth of General Electric (NYSE:GE) and $100,000 worth of Doctor Pepper Snapple (NYSE:DPS). I look on Morningstar.com, Google finance or some similar site, and find that GE has a Beta of about 1.5, meaning, if the stock market moves 1% in either direction, GE is prone to moving 1.5% in the same direction. I'd also find that DPS has a Beta of about .16. Since 50% of my portfolio has a Beta of .16 and 50% has a Beta of 1.5, my total portfolio has a combined Beta of .83.
Next, I calculate the expected return for my portfolio, which is simply equal to:
(risk free rate of return) + Beta times (S&P500 return - the risk free rate of return).
Let's suppose the total rate of return on the S&P500 this last year has been about 18%, plus 1.8% in dividends - about 19.8% in total return. Let's further suppose that the average risk-free rate of return over the last year is about 2.5%. I would calculate that the expected return of my portfolio is equal to:
2.5% + .83 x (19.8%- 2.5%) = 16.86%.
I could just as easily have used a five-year or ten-year average return, or any other time period for that matter. The question is really how long or short a time frame do I want to five my investment manager to prove his value added.
Third, I calculate the Alpha on my portfolio, which is simply the difference between the expected return on my portfolio (16.86%) verses how well or poorly my portfolio actually performed over the same time period. Looking over the past year, a $200,000 portfolio comprised 50/50 of GE and DPS returned about 18.75%, with a combined dividend yield of close to 3%, for a total return of 21.75%. Accordingly, the Alpha on my portfolio is equal to:
21.75% - 16.86% = 4.89%
On its own, my portfolio Alpha doesn't tell me whether I should fire my investment manager or not. To make that decision, I need to compare that to the Alpha that my next best alternative portfolio has produced over the same time period. Again, in my case, that would be a passive portfolio consisting weighted 70% into VT and 30% into BND.
I look on Google Finance (or some comparable site) and see that the Beta for BND is -.05 and the Beta for VT is 1.14. The total combined Beta on my next best alternative portfolio is .783 - slightly less than the .83 Beta for my actual portfolio, but not too far off. I then determine the expected return for my next best alternative portfolio, which is simply:
2.5% + .783 x (19.8%- 2.5%) = 16.05%.
Finally, I calculate the Alpha on my next best alternative portfolio, which is the difference between the expected return (16.05%) verses the actual return on this portfolio. Looking over the last year, a $200,000 portfolio comprised 30/70 of BND and VT would have returned about 10.6%, plus a combined dividend yield of close to 2.4%, for a combined total return of nearly 13%. The Alpha on my next best alternative portfolio is the difference between 13% and 16.05, or close to -3.05%.
It's easy for me now to decide whether or not to fire myself. I take the difference between the Alpha on my actual portfolio (4.89%) and the Alpha on my next best alternative portfolio (-3.05%), and find that the Delta between these two portfolios is 7.94%. That's my value-added to my investment business. Any positive Delta between my actual portfolio and my next best alternative portfolio means I don't want to fire my investment manager, and the higher that Delta goes, the more fervently I want to keep him.
That is, assuming he wants to keep the job. At this point, I have to switch hats. As an employee of any business, my primary (but by no means exclusive) consideration for whether to quit or not comes down to how much my employer is willing to pay me for my time, and how much money other employers might be willing to pay me for my time. Since I'm responsible for investing a $200,000 portfolio, and since I generate a delta of 7.94%, the value of my time and effort is simply $200,000 times 7.94%, or $15,880 a year. I divide that by the total number of hours I spent last year actively managing my portfolio, and then see what hourly rate I'm being paid. As long as the hourly rate I earn working for my investment business is close to what I'd earn working for someone else, I can start to consider all the secondary benefits or costs of working for my own investment business. Does it give me enough free time and flexibility, would I prefer working in a more team-oriented environment, am I comfortable living with a highly uncertain paycheck?
If you are an individual investor, you can use an objective framework like this to help decide whether you're doing yourself any favors by investing your own money, and if so, just how big a favor.