Benchmarking Your Portfolio Against the 'Retirement Ratio'

by: Lowell Herr

Portfolio management goes beyond buying stocks, bonds, ETFs, mutual funds and other investment vehicles to populate the asset classes, according to a strategic asset allocation plan. If one is to manage a portfolio there needs to be some reference measurements in place to know how well the portfolio is performing with respect to benchmarks. One such benchmark is known as the Sortino ratio. In this article, the Sortino ratio serves as a model for measuring the return/uncertainty ratio of a portfolio.

I'll title this ratio the Retirement Ratio (RR) and it looks like the Sortino ratio with a slightly different twist.

RR = (Return - PTR)/DU where

Return = Internal Rate of Return (IRR) for the portfolio.

PTR = the Portfolio Target Return and I will amplify how PTR is determined as this is where the RR differs from the SR.

DU = Downside Uncertainty or what is generally referred to as Downside Risk. The term Risk carries many meanings and that is why I prefer to use Uncertainty.

PTR is the target return set up by the investor. PTR, in the RR calculation, is the higher of two values.

1) The first option is the IRR of a benchmark such as Vanguard's Total Stock Market Index Fund, (VTSMX), or a customized benchmark that reflects the different percentages one invests in different asset classes. A customized benchmark is preferred, but difficult to calculate accurately.

2) The second PTR option is the current inflation rate plus the annual withdrawal rate the retiree expects to extract from the portfolio. The withdrawal rate usually runs from 2% points to 5% points.

Downside uncertainty is a semi-variance calculation that requires a benchmark within the calculation. The reason for using a semi-variance calculation instead of standard deviation is that a portfolio manager should not be penalized for upside volatility as that is what we want to see in a portfolio. It is desirable for a portfolio to move up in value faster than the benchmark. Semi-variance only penalizes volatility to the downside. Harry Markowitz recommended using a semi-variance calculation back in 1952 when he was writing his Nobel Prize paper, but the computing power was not available. This limitation no longer stands in the way of calculating semi-variance.

The following example illustrates an RR calculation using data from an actual portfolio.

Return = Portfolio IRR of 11.9%.

PTR is the higher of two values.

1. The withdrawal rate plus inflation equals 7.2%.

2 The IRR for our benchmark is 7.30%.

DU = 2.02%. A minimum of three years of data is required for this value.

PTR is 7.30% since this value is greater than inflation plus withdrawal rate.

RR = (11.9 - 7.30)/2.02 = 4.60/2.02 = 2.28 or 2.3

Think about the equation for a moment. We want the numerator to be positive as a minimum standard. This means the IRR for the portfolio exceeds our Portfolio Target Return. Each investor will set up their own PTR. I use the higher of two values. In addition, we want DU to be low as low volatility to the downside is highly desirable. The higher the numerator and the lower the denominator the greater the RR value, and that is the goal.

Readers needing help calculating DU will find it at this site.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. While I have written on this subject within my ITA Wealth Management blog, this article is unique.