Two types of risk adjustment procedure have been considered, those that adjust for the total risk of the portfolio (the coefficient-of-variance and Sharpe measures) and those that only adjust for the systemic risk of the portfolio (Treynor and Jensen measures). The use of these measures is now considered.
Ultimately, under the framework of the CAPM, the investor seeks average returns that are above the capital market line i.e. that are superior, after adjusting for total risk, to those which could be obtained by combining risk-free borrowing or lending with the market portfolio. It was noted above that negative risk-adjusted returns, after adjusting for systemic risk, are sufficient to guarantee negative risk-adjusted returns after adjusting for total risk. However, the converse is not true. Finding positive risk-adjusted returns after adjusting for systemic risk is not sufficient to ensure positive risk-adjusted returns after adjusting for total risk.
Note, however, the benefits suggested by diversification. By combining portfolios that have positive excess returns after adjusting for systemic risk, but negative excess returns after adjusting for total risk, the creation of a portfolio of portfolios that has positive excess returns - even after adjusting for total risk - may be possible.
The evaluation of performance therefore rests on one of the cornerstones of finance - the received theory of risk in equilibrium - the CAPM. The following chapter will therefore review the development of the CAPM, and those issues of particular relevance to its use in the evaluation of real estate's performance.