Evaluation of portfolio performance, the bottom line of the investing process, is an important aspect of interest to all investors and money managers. The framework for evaluating portfolio performance consists of measuring both the realized return and the differential risk of the portfolio to use to compare a portfolio. s performance, and recognizing any constraints that the portfolio manager may face. A 12% return, by itself, is a fairly meaningless figure. It must be viewed in comparison to the performance, over the same timeframe, of alternative investments bearing a similar level of risk.

Remember, one can only measure return in relation to the risk taken. Investing is always a two-dimensional process based on return and risk. These two factors are opposite sides of the same coin, and both must be evaluated if intelligent decisions are to be made. Therefore, if we know nothing about the risk of and investment, there is little we can say about its performance. Given the risk that all investors face, it is totally inadequate to consider only the returns from various investment alternatives. Although all investors prefer higher returns, they are also risk averse. To evaluate portfolio performance properly, we must determine whether the returns are large enough given the risk involved. If we are to assess performance carefully, we must evaluate performance on a risk-adjusted basis.

We must make relative comparisons in performance measurement, and an important related issue is the benchmark to be used in evaluating the performance of a portfolio. The essence of performance evaluation in investments is to compare the returns obtained on some portfolio with the returns that could have been obtained from a comparable alternative. The measurement process must involve relevant and obtainable alternatives; that is, the benchmark portfolio must be a legitimate alternative that accurately reflects the objectives of the portfolio owners.

An equity portfolio consisting of S&P 500 stocks should be evaluated relative to the S&P 500 Index or other equity portfolios that could be constructed from the Index, after adjusting for the risk involved. On the other hand, a portfolio of small capitalization stocks should not be judged against that same benchmark. If a bond portfolio manager. s objective is to invest in bonds rate A or higher, it would be inappropriate to compare his or her performance with that of a junk bond manager. Even more difficult to evaluate are equity funds that hold some madcap and small stocks while holding many S&P 500 stocks. Comparisons for such a widely diversified group can be quite difficult.

The S&P 500 has been the most frequently used benchmark for evaluating the performance of institutional portfolios such as those of pension funds and mutual funds. The S&P 100 and the Wilshire 5000 index are also popular. Many observers now agree that multiple benchmarks can be more appropriate to use when evaluating portfolio returns. All investors should understand that even in today. s investment world of computers and databases, exact, precise, universally agreed upon methods of portfolio evaluation remain an elusive goal. An evaluation is imperative, though, and it is unfortunate that some studies have indicated that most investors don. t have a good idea how well their portfolios are actually performing.