A CENTRAL PROBLEM IN FINANCE (and especially portfolio management) has been that of evaluating the “performance” of portfolios of risky investments. The concept of portfolio “performance” has at least two distinct dimensions:
The ability of the portfolio manager or security analyst to increase returns on the portfolio through successful prediction of future security prices, and
The ability of the portfolio manager to minimize (through “efficient” diversification) the amount of “insurable risk” born by the holders of the portfolio.
The major difficulty encountered in attempting to evaluate the performance of a portfolio in these two dimensions has been the lack of a thorough understanding of the nature and measurement of “risk.” Evidence seems to indicate a predominance of risk aversion in the capital markets, and as long as investors correctly perceive the “riskiness” of various assets this implies that “risky” assets must on average yield higher returns than less “risky” assets.1 Hence in evaluating the “performance” of portfolios the effects of differential degrees of risk on the returns of those portfolios must be taken into account.