Risk Comes From Not Knowing What You Are Doing

As Warren Buffett's quote above refers to, risk is not knowing or understanding what you are doing.

To help combat this "risk," I’ve put together a list of some important measures to consider when evaluating your investment portfolio.

These metrics can be used to measure individual stocks, ETFs, and mutual funds.
 
Underlying Holdings: Probably the single most important information to know. This is the driver of how your portfolio (or the fund) has performed in the past and how it will perform in the future. Know what you own and why.

Geographic Exposure: Measures where in the world are the funds’ largest holdings located geographically. Where are these companies based? Are they located in U.S., European, or in Asia? Why is this important? Different countries have different accounting standards, regulatory requirements, and governmental intervention. 

Weighted Average PE Ratio: Measures what the weighed average price/earnings ratio is of the funds’ underlying holdings. The higher the number, the more investors are paying for every dollar of earnings. All else being equal, lower is better.

Valuation Percentage: The valuation percentage shows how far above or below its current price the stocks or funds historical valuation is. This factors a long-term average of the Price to Sales Ratio and Price to Earnings Ratio and mathematically determines whether the current price is high or low relative to those historic valuation multiples. A negative value indicates the current price is above the historical valuation while a positive value indicates it is currently trading at a discount to the historical valuation. This is NOT a measurement of how the stock's price relates to its "intrinsic value” but is instead a measurement of how the market is valuing the stock or fund relative to how it was valued historically.

Return on Equity (ROE): Measures the rate of return on the money invested by stock owners. ROE shows how well a company uses investment funds to generate income and growth. Return on equity is useful for comparing companies within a sector and industry. It’s also useful at the fund and portfolio level. Return on Equity = Net Income / Average Common Shareholder's Equity. All else being equal, higher is better.

Dividend Yield (and Current Yield): The sum of all dividends paid (and interest paid), divided by current share price; a higher dividend yield (and current yield) indicates a larger payout.

Dividend Payout Ratio: The percentage of company net income paid as dividends to shareholders. Typically, investors who want income from their investments favor a higher dividend payout ratio.

Dividend Growth: Period over period growth of dividends paid, usually expressed as trailing 12-month (TTM) growth. Growth in dividends can be a sign of strong financial health.

Dividend Consistency: The track record of paying dividends to shareholders at a regular interval, usually quarterly, over a given lookback period; a company cutting or canceling a dividend payment is a negative event.

Total Returns: Unlike price return, total return includes dividends and interest in addition to price appreciation; a higher total return is better. It’s important to look over various time periods and under various market conditions (Bull markets, Bear markets, and sideways markets). As I’m sure you’ve heard before, “past returns are no guarantee of future returns.”

Sharpe Ratio: The Sharpe Ratio measures the risk-adjusted return of a security. This is a useful metric for analyzing the return you are receiving on a security in comparison to the amount of volatility expected. Sharpe Ratio is measured as annualized return on Lookback Period - Risk-Free Rate) / Historical Annualized Standard Deviation of Monthly Price Returns.

Benchmark: For a security, a fund, or a portfolio, a benchmark is used to track against. Generally, the benchmark is an index or weighted return stream of multiple indices that help give an idea of what your investment should strive to match or beat. Measuring against the proper benchmark is critical to properly understanding performance and risk. Benchmarks are also used to calculate risk metrics like Alpha, Sharpe Ratio, and Beta for securities and portfolios.

Upside/Downside Capture Ratio: The upside/downside capture ratio measures the ratio of the upside and downside of an investment vs a benchmark. This ratio explains how an investment typically performs in relation to their benchmark index. An upside/downside ratio of 100 means that the investment typically performs the same as the benchmark, regardless of if it is rising or falling. If the benchmark increases by 10%, the investment increases by 10%. If the benchmark decreases by 5%, the investment decreases by 5%. Sometimes, an investment may rise 15% when their benchmark rises by 10% but falls 12% when the market falls 10%. In this case, we calculate the upside/downside capture ratio by dividing the investment's upside return and dividing by the downside return: (.15/.10)/(.12/.10) = 1.25. Multiplying this by 100 gives us an upside/downside capture ratio of 125 for this investment. All else being equal, higher is better.

Expense Ratio: The percentage of fund assets that shareholders pay as management fees and operating expenses. A lower expense ratio means less fees. All else being equal, lower is better.
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Market Cap Allocation: The percentage of fund assets invested in large-cap, mid-cap, and small-cap stocks.
 
Understanding what you own and why is critically important. What I argue is even more important is understanding that having 100% accuracy to what the future holds is impossible, so taking measured risks is really what investors are doing when they invest.
 
As Napoleon said, "Nothing is more difficult, and therefore more precious, than to be able to decide."
 

-Paul R. Rossi, CFA