A benchmark acts as a standard by which to compare other investment portfolios. We can evaluate the performance of an investment by comparing it with the appropriate benchmark index. For instance, a portfolio may have gained 5%, but if the general stock market went up by 7%, the market return benchmark indicates that the portfolio actually realized a 2% loss.
Most major indexes use specific criteria like sizing and credit ratings to determine which securities should be included. Indexes typically use market capitalization weighting instead of simply averaging the prices. Companies with more equity will be weighted more, and therefore have a greater influence on the index.
There are many more financial indices or index funds out on the market. Most individual investors like to benchmark their portfolio with some common indices such as the Dow Jones Industrial Average (DJIA) or S&P 500. The following is a list of common benchmarks:
The DJIA includes 30 large companies and is price-weighted instead of market-capitalization-weighted. It is the oldest commonly-used stock benchmark in the U.S.
The S&P 500 Index includes the performance of the 500 largest U.S. companies. It is the most common stock market benchmark in the U.S.
The Russell 2000 Index includes the performance of 2,000 small-cap U.S. companies. It is a good tool for evaluating many small-company funds.
The Russell 3000 Index includes the performance of the 3,000 largest U.S. companies. It is meant to represent the entire U.S. market as accurately as possible.
The MSCI EAFE Index follows international stocks and is a good measuring tool for portfolios that hold international stocks.
The Barclays Capital Aggregate Bond Index focuses on investment-grade bonds being traded in the United States.
When choosing a benchmark, the asset classes of the portfolio should match with an appropriate benchmark. The benchmark can differ depending on individual investment strategy or mandate. The S&P 500 could be a good benchmark for a portfolio of large-cap U.S. stocks, but not for measuring the performance of a portfolio consisting of bonds and real estate. Some standards that should be considered when choosing a benchmark:
The benchmark should clearly define the securities it includes and the weighting methodology.
The benchmark should contain securities that are tradable.
The benchmark should be calculated on a regular basis.
Historical returns of the benchmark should be available for reference.
The index should not constantly change the securities it consists of.
The benchmark's detailed risk metrics should be disclosed regularly.