Benchmark: What It Is, Types, and How to Use Them in Investing

September 30, 2022

What Is a Benchmark?
A benchmark is a standard against which something is compared. Investors use benchmarks to measure the performance of securities, mutual funds, exchange-traded funds, portfolios, or other investment instruments.

Generally, broad market and market-segment stock and bond indexes are used for this purpose—even cryptocurrencies have benchmarks, hallmarking the importance of having something to compare an asset’s performance to.

If there is an investment instrument, there is a benchmark to compare it to—learn more about benchmarks and how you can use them to check your portfolio’s performance.

Understanding Benchmarks
Market benchmarks are indexes created to include multiple securities, assets, or other instruments to represent the performance of a stock, fund, or any other investment of the same type and composition.

Benchmark indexes have been created across all types of asset classes. For example, the S&P 500 and Dow Jones Industrial Average are two of the most popular large-capitalization stock benchmarks in the equities market.

Equity Indexes
The S&P 500 was created by Standard & Poor’s. It lists 500 companies—there are actually 505 stocks on the index—based on specific metrics and valuation techniques that reflect the best-performing stocks on the stock market (according to the professionals at S&P).

The Dow Jones Industrial Average comprises 30 U.S. blue-chip stocks—the stocks of well-recognized, established, and financially sound companies.

The S&P 500, of course, has many more stocks listed on it than the Dow does, but there are many similar stocks:

Apple
Microsoft
Boeing
Alphabet (Google)
Cisco
Caterpillar
Proctor & Gamble
Both of these indexes are used by many to gauge the performance of the stock market as a whole, even though they only represent a fraction of the stocks listed on public exchanges.

Mutual fund investors may use Refinitiv Lipper indexes, which use the 30 largest mutual funds in a specific category, while international investors may use MSCI Indexes. The Wilshire 5000 is also a popular benchmark; it represents all of the publicly traded stocks in the U.S.

Fixed Income Indexes
Fixed income indexes measure the performance of fixed income assets like bonds and treasuries, which investors use for generating income or as a way to preserve capital during falling market conditions.

Some examples of top fixed income benchmarks include the Bloomberg Aggregate Bond Index (known as the Agg), the Bloomberg Capital U.S. Corporate High Yield Bond Index, and the Bloomberg Capital U.S. Treasury Bond Index.

Commodity Indexes
Commodity indexes measure the performance of a basket of commodities. For example, the Bloomberg Commodity Index (BCOM) consists of 23 exchange-traded physical commodities futures. The index measures 21 commodities across five different sectors and acts as an indicator of the performance of the commodities market. The five sectors are:

• Agriculture
• Energy
• Industrial Metals
• Precious Metals
• Livestock

In addition to traditional benchmarks representing broad market characteristics such as large-cap, mid-cap, small-cap, growth, and value, you’ll also find indexes based on fundamental characteristics, sectors, dividends, market trends, investing themes, and much more.

Using a Benchmark
When evaluating your investment portfolio’s performance, it’s important to compare it against a benchmark representing the industry, sector, and market segment to which it belongs. However, if your portfolio is diversified, you may not be able to compare the total portfolio against one index—you may need to evaluate it in sections based on how you’ve allocated your investments.

Using Information Already Provided
Most retail investors don’t build their portfolios by choosing individual stocks. However, it is possible to do so—but in many cases, it is simply too expensive and time-consuming to evaluate stocks and purchase the ones that meet your investing criteria. So, many choose mutual funds or exchange-traded funds (ETFs) that mirror the performance of specific indexes.

If you have a fund—or more than one—in your portfolio, you can compare the information fund managers already provide to see how your funds are doing compared to the indexes they mirror.

The Bottom Line
Market benchmarks are important because they allow investors to compare their holdings’ performance against reliable metrics. Additionally, benchmarks indicate the health of a market—you can also see how a particular class is performing or view the equities market performance as a whole. Market benchmarks constantly evolve, with new ones occasionally appearing based on changing investing strategies and investor sentiments.

The one limitation benchmarks have is that they are indicators of past performance—there is no way of knowing how the investments that comprise an index will perform. You can only view the results of your investment decisions—which is a good thing because you can use the information to make adjustments or readdress your strategy.

By: James Chen | From: Investopedia.com

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