- Performance metrics standardize measures of success for an investment.
- Many performance metrics exist, and each one will generate a unique answer about how well an investment performed.
- Investors must think carefully about what metrics make the most sense for a given asset or strategy.
Why Investors Use Performance Metrics
For most investors, the singular goal of investing is to make money. However, measuring the performance of an investment is much more complicated than assessing how much money was made or lost from an investment. The overall success of a trade depends on how much money was invested and how long that capital was deployed, among other factors.
Performance metrics allow investors to standardize the measurement of their returns. Metrics that account for the amount invested will indicate which strategy provided better returns, regardless of how much an investor was able to deploy. Similarly, metrics that account for time will indicate how quickly an investment generated income. Given the positive time value of money, a quicker return is always better than a slower one.
Performance metrics for Bitcoin are not inherently different from performance metrics for other assets. However, Bitcoin ownership does not directly generate cash flows, whereas ownership of many other assets does. This difference simplifies performance metrics for Bitcoin, as cash flows only occur during buy and sell transactions. Other unique factors of Bitcoin shape which metrics make the most sense as well.
Bitcoin Performance Metrics
One of the simplest performance metrics is a percentage-based return. This metric accounts for the amount of capital used to enter a position and shows the return proportional to the cost basis. Percentage-based returns can also be measured over a period of time, by considering the market value of the asset at the beginning of the window as the cost basis.
The internal rate of return is a measure of performance that accounts for both the initial investment amount and the time needed to generate returns. This metric solves for the average compounded rate of return over a time period, usually a year, that would bring the investment from its starting value to its ending value.
For example, an investment that increased in value from $100 to $121 over the course of two years would have an internal rate of return of 10% per year. This is because a 10% increase in the first year would make it worth $110, and a 10% increase on that $110 the second year would bring the market value of the investment to $121. The greater nominal return in the second year is the result of compounding returns.
Benchmark investment metrics aim to compare the return of an investment with a benchmark return that would have been generated by another investment. This comparison could make sense for an investor looking to see how much better the investment was than an alternative. A key assumption with this metric is that the money would have been invested in an asset for sure, and it was just a question of which one.
Benchmark investment metrics can compare returns with that of any other asset. However, these metrics generally compare returns to those of safe and high volume assets. The S&P 500 index is a commonly used benchmark to indicate how an investment performed relative to the market as a whole.
Benchmark investment metrics are more informative when they are compared with the alternative asset that an investor would have actually chosen. For this reason, gold is a commonly referenced benchmark asset for measuring Bitcoin returns. The similarities between Bitcoin and gold tend to attract similar investment strategies, in a way that Bitcoin and the S&P 500 do not.
Certain sophisticated investment metrics consider factors beyond the starting and ending value of an investment. For example, an investor could look at the value of the investment over many intervals to determine the volatility of the asset. This can be used to inform the overall risk of a position, and this risk can be weighed against the final return that was generated.
The Sharpe Ratio is a commonly referenced metric that uses volatility as an input in the performance of an asset. Additionally, the Sharpe Ratio implements the benchmarking strategy of discounting returns by those of another asset. The benchmark used in the Sharpe Ratio is the “risk-free rate” earned on government issued debt.
The performance metrics described above are only a few of the countless ways that investors aim to measure their returns. Different metrics serve different goals, and often many will be used simultaneously to better understand the success of an asset or a portfolio.