What is a benchmark?
This is done by using a broad market index which uses multiple securities to reflect a particular segment of the market.
Benchmarks are particularly helpful resources for investors, and identifying the correct benchmark to guide your portfolio is crucial. A person with heavy investments in British commodities, for example, shouldn’t use the Japanese Nikkei as a benchmark – after all, the Japanese market does not reflect any developments surrounding British commodities.
There are a whole range of benchmarks focussing on particular industries, sectors, and asset classes. So depending on what your financial goals are, use a benchmark that best identifies the right securities for your portfolio. No one should be walking into investing blind, so consider benchmarks your friendly guides to constructing your portfolio!
KEY TAKEAWAYS
- A benchmark is a reference for investors to measure the performance of their portfolios against
- Tracking market indexes, such as the S&P 500, benchmarks helps investors to construct their portfolios
- There are a whole range of benchmarks focussing on particular industries, sectors, and asset classes
- The Dow Jones Industrial Average, the S&P 500, or the Russell 2000 are examples of large-cap benchmark indexes
Benchmark index
Benchmark indexes include multiple securities reflecting a particular area of the market. The Dow Jones Industrial Average, the S&P 500, or the Russell 2000 are examples of large-cap benchmark indexes, and can be used to measure other stocks or securities in the market. You can also find medium- and small-cap indexes. It all depends on what your financial goals are!
Market benchmarks
Market benchmarks allow individual investors to monitor performance of a security by measuring it against particular market segments. For example, you might have a lot of tech investments in your portfolio, so following a technology index such as the NASDAQ 100 can help track the performance of the tech industry as a whole, while helping you assess which tech companies are worth including in your portfolio.
Benchmark error
This is a situation we don’t want! A benchmark error occurs when a manager applies the wrong benchmark to their strategy and ultimately muddles the analyst’s data, leading to inaccurate calculations which either overstate or understate a portfolio’s performance.
Picking the wrong benchmark can have serious consequences. However, the risk surrounding benchmark errors is easily mitigated by simply choosing the right benchmark from the onset. Accuracy and due diligence are key!
Passive funds
Since it became increasingly expensive to purchase various individual assets to build a well diversified portfolio, passive funds were set up. Passive funds allow individual investors to pay a small fee whereby the manager only needs to replicate a particular index.
An example of a passive fund is the SPDR S&P 500 ETF (SPY) which replicates the S&P 500 Index. These are a low-cost, hassle-free approach to investing which simply relies on benchmarks for the investment manager to replicate.