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Investment Benchmarking | A Simple Comparison Tool That Helps You Hit Goals
To gauge growth, you need to measure it, and that requires a measuring device. Carpenters use a tape measure, fruit sellers use a scale, and investors use standardized portfolios called benchmarks.
Sure, you might be making money, but are you optimizing your gains? Do your gains match your risk exposure? Do your losses indicate that you’re doing everything wrong?
In this article, we’ll explain how you can use benchmarks to analyze your portfolio to be a better, more informed, and more precise investor.
Investment Benchmarks Explained
A benchmark is just a reference point used to measure something else. We could benchmark our portfolio against any random stock or fund, but that probably wouldn’t tell us anything useful. Instead, we need an objective standard of measure.
An index is a standardized portfolio of stocks investors often use for benchmarking. These indexes (or indices) are designed to create a clear picture of average performance for a specific asset class.
Examples include blue-chip stocks, tech stocks, emerging markets, commodities, real estate, bonds, or just about any other interesting sector. If there is a market for an investment, an index likely exists to measure it.
Why Are Indexes the Perfect Benchmark?
Indexes are designed and managed by reputable investing institutions such as Dow Jones, Standard & Poor’s (S&P), or Morgan Stanley Capital International (MSCI). Indexes must be transparent so everyone can see exactly what’s happening inside, and indexes must be investable, so it’s possible to replicate the index.
It’s important to note that an index is not an investment fund. You can’t put money in an index. Instead, you can invest in a mutual fund or exchange-traded fund (ETF) that tracks an index as closely as possible (replication strategy) – but it will never be exact.
How Investment Benchmarking Helps You Hit Goals
Benchmarking helps you become a better investor by letting you measure portfolio performance and manage portfolio risk.
The first question most people ask is, “how is my portfolio performing?” This question is tough to answer if you don’t have something to compare it to. Benchmarks provide a comparison so you can answer the question objectively.
In simple terms, you can look at a chart of a benchmark (e.g., the S&P 500) over time and compare it to your portfolio over the same period. From this, you can clearly see how your portfolio performance stacks up against the market.
If you’re outperforming the market, that’s great, and you should continue following your strategy. If you’re underperforming, it might be time to make some changes.
The second question we want to know is, “how much risk is built into our portfolios?” It’s important to know if your gains justify the risks you are taking, and benchmarks can help.
One way risk gets assessed is by measuring volatility. By comparing your portfolio’s volatility with the benchmark’s, you can objectively measure your risk – and, more specifically, whether that risk matches your risk tolerance. Basically, this means that the more extreme the price swings of your investments, the more risk inherent in the investment.
Your portfolio needs rebalancing if you have more risk exposure than the benchmark but are underperforming.
Choosing the Right Benchmark
Before you use a benchmark to measure your portfolio, you must select the index best suited to give you the information you want. For example, if you want to know how your stock picks performed compared to the stock market, benchmark your portfolio against a stock index, not a bond index.
So, choosing the right benchmark depends on which question you’re asking about your portfolio. For example, you might ask:
- How did my portfolio perform compared to the overall stock market? In this case, we would benchmark our portfolio against a broad stock index such as the S&P 500, which will show if we under or over-performed by comparison.
- Would I have been better off putting my money in risk-free investments (bonds)? Here we would benchmark our portfolio against a bond index such as the Bloomberg Agg and compare our performance. If our stock picks performed the same or worse than bonds, we know we took the excess risk with nothing to show for it.
- How did my portfolio risk profile compare to the overall stock market? Here we would benchmark our portfolio against a total market index such as the Dow Jones to see if we’re taking more or less risk than the market average.
- How does my portfolio compare to a similarly diverse collection of indexes? Now, we want a benchmark that matches the exact asset allocation in our portfolio, which might include large-cap stocks, global stocks, bonds, real estate, and more. In this case, we need to find benchmarks for each of our asset categories, then create an index portfolio allocated to match our specific investments.
These are simple examples, but you could ask any number of questions about your portfolio and use a benchmark – or combination of benchmarks – to find the answer. The comparison will give you the insight you need to make more effective investing decisions.
Common Stock Market Benchmarks
Here are a few U.S. indexes commonly used as benchmarks by investors and institutions. Remember, there is an index out there for just about anything, but these common indexes will meet most of your benchmarking needs.
- Dow Jones Industrial Average. Average of 30 publicly traded U.S. blue chips stocks.
- S&P 500. Average of 500 large U.S. companies.
- Nasdaq Composite. Average of Nasdaq listed companies primarily focused on tech.
- Russell 2000. Average of 2000 small-cap companies.
- Wilshire 5000. Total-market average of most actively traded U.S. stocks.
- Bloomberg Barclays U.S. Aggregate Bond Index. Primary U.S. bond index.
- Dow Jones U.S. Select REIT Index. Real estate index.
How to Track Portfolio Performance Against a Benchmark
Okay, you know how benchmarking works and why it’s valuable, but how do we implement it? Here we’ll show you a simple example of benchmarking a portfolio using StockMarketEye.
- Choose a portfolio to benchmark. For our example, we’ll use a portfolio that contains 100 shares of Apple (APPL) that we bought at $175 per share. Of course, a real portfolio will be much more diverse.
- Decide what we want to know. Ask yourself what you want to know about your portfolio. In this case, we want to know how our portfolio performed compared to the market average.
- Open StockMarketEye.
- Select your portfolio. You’ll see three options on the left side of the Portfolio Properties screen. Choose Portfolio. In the Benchmark Symbol dropdown menu, choose ^GSPC, which is the symbol for the S&P 500 index. Click Apply.
- Choose a benchmark. On the left side of the Portfolio Properties screen, you’ll see three options. Choose Portfolio. In the Benchmark Symbol dropdown menu, choose ^GSPC, which is the symbol for the S&P 500 index. Click Apply.
- Open Configure Columns settings. Hover your mouse over any portfolio column, and three lines will appear. Click on the three lines to open the menu. Choose Configure Columns.
- Add benchmarking columns. In the Configure Columns settings box, you will see two text boxes. The box on the left displays all the possible column options available, and the box on the right displays the columns currently in view. In the left box, scroll down to the bottom to find the column options for benchmarking. Click the + next to the benchmarking options to move them to the right column. Click Apply.
- View the total portfolio chart. Click on the total row at the bottom of the portfolio window to display your combined value in the chart window below.
- Set the date range. Click on the date range menu on the upper right side of the chart window, and set the time frame you want to analyze. We’ll be looking at all of 2022.
- Display benchmark graph. Click on Compare to… and choose ^GSPC.
- Analyze graphs. A red line will appear, indicating the performance of the S&P 500 benchmarked to your portfolio. The line estimates how the same investment you made in your portfolio would have performed if it had been invested in the index instead.
How is Your Portfolio Stacking Up?
Now you should have a better idea of benchmarks and how to use them to be a better investor. Precision requires measurement, and we can’t measure anything without a measuring tool, whether it’s a ruler, a scale, or – in this case – an investing benchmark.
The benchmarking process can be much more complex, but it will always follow this basic process. It comes down to what questions about your portfolio you’re trying to answer and how much detail you want to analyze.
If you’re managing your own portfolio and would like to try benchmarking, check out our portfolio management and consolidation software. We offer a no-risk, 30-day free trial, so you can see if our software is right for you. Give it a try today!