CHAPTER 1

What Is Performance and Benchmarking?

THE BASIC ISSUE: HAS YOUR WEALTH INCREASED?

If we receive a $5,000 bonus check because we sold more widgets than ourcompetitors did, we can either spend the money now or we can defer spending itnow and let it grow in an investment. Say we had invested our $5,000 in acertificate of deposit (CD) and our account grew to $5,050 over a period ofthree months. We earned $50 on a $5,000 investment or 1 percent over threemonths, or about 4 percent per year on our investment. If we think that the $50earned on a $5,000 investment is not a reasonable return, then we might beinclined to spend $5,000 and not invest it or look for an alternative higher-payinginvestment.

To make investment choices we must have the proper data and information aboutthe return on investments and the risk of not being paid. This relatively simplenotion of performance measurement and evaluation is basic to all investments.The decision to consume today or defer consumption by investing for tomorrow isabsolutely fundamental to all economic activity. Economic growth depends oninvestors deferring consumption so that the money can be invested for thefuture. No factory is built, no new company is capitalized, and no economicgrowth is possible without this deferred consumption.

The confidence that people have that their investments will earn sufficientcompensation in the future is critical to justifying their deferring consumptiontoday. Hence, it is fundamental to any economic system.

Instances of hyperinflation such as in Zimbabwe in 2007, Argentina in the 1990s,or Germany in the early 1930s create very challenging environments for economicactivity. Investors ask themselves why anyone would put money in a bank, buy astock, buy a bond, or invest in anything if the payoff cannot be expected toexceed the very rapid rise in prices. Being able to reasonably anticipate thepayoff we will receive for investing is absolutely critical.

The institutions that gather money from investors and distribute it to users ofcapital make up the financial system. The more efficient and effective thecollection and distribution of capital, the more efficient the economy will be.Essential to this operation is the ability to correctly assess the performanceof various investment alternatives. New companies or companies seeking to expandattempt to raise capital by persuading potential investors that their investmentwill be rewarded. If investors are unable to calculate before or after the factwhether the promises or expectations of an investment were met, they will notinvest. This flow of information is fundamental to the efficient allocation ofcapital within an economy toward productive activities and enterprises thatincrease wealth and away from activities and enterprises that are lessproductive. In this sense, anything investors can do to improve the performanceevaluation techniques and methods that they use makes a positive contribution byhelping the economic system to more efficiently allocate their savings (i.e.,capital) and thereby maximizing economic growth.

WAS THE CHANGE IN WEALTH WORTH THE RISK?

If investors want their investments to grow more than in a savings account, thenthey are going to have to invest in enterprises whose outcomes are uncertain.Most investors comparing alternatives that provide the same return, the samepromised payoff, will choose the alternative that is less risky. If a company'smanagement wants investors to invest in its enterprise but the outcome of theenterprise is not certain, the company has to offer a higher return potentialthan comparable less risky investments.

This leads to the second dimension of the investment problem—risk. When wecalculate our growth in wealth, we want to balance that knowledge with anassessment of the risk we undertook to achieve that wealth. The problem with theterm risk is that it's not easy to measure in a way that satisfies allinvestors. In this book we will examine various definitions and measures ofrisk.

The preceding considerations lead us to this definition of performancemeasurement:

Performance is the return or the increase in wealth over time of an investmentrelative to the amount of risk the investor is taking; that is, performancemeasurement provides a risk-adjusted return assessment.

So the first central problem in performance measurement is to assess theincrease in wealth over a given time frame. Then we must view this return interms of some measure of the risk we took to obtain it. If we have more than oneinvestment opportunity, we will want to compare these investments in terms oftheir reward relative to their risk. In the first part of this book we focus oncalculating different measures of wealth growth and different measures of riskcalculation. The objective is to provide tools for calculating risk-adjustedreturn.

COMPARING RETURN WITH ALTERNATIVE INVESTMENT RETURNS

After we have calculated our growth in wealth and have assessed the risk...