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Using An Appropriate Benchmark

Benchmarks were constructed to give investors an appropriate yardstick against which they could measure their returns in relation to various asset classes during any given period of time. Used as objective standards of performance, benchmarks are as numerous as the various asset classes available, yet are easily adapted to match any investor's needs. Benchmarks are a critical tool in the investment industry, not only for assessing the performance of individual investors, but also for fund managers who are typically compensated on the basis of their performance relative to a benchmark.

To find the appropriate benchmark to which to compare your own portfolio, you first need to know the different types of benchmarks that are available, as well as the benefits and drawbacks of each.

Indices as Benchmarks

The most widely used benchmark is the index, which is a predetermined group of stocks perceived to have some significant correlation to either the overall performance of the stock market or a segment of the market. Although the Dow Jones Industrial Average (DJIA) may be the topic of many business related newscasts, professionals generally do not use it as a performance benchmark. This is because the DJIA is composed of only 30 giant blue chip stocks, giving us a very narrow indicator of the thousands of currently traded stocks.

The index most commonly used as a benchmark for growth-oriented investors is the Standard & Poor's 500 Index, a market-value-weighted index of 500 major U.S. companies. Probably the biggest advantage of the S&P 500 is that it is widely used and easily tracked through newspapers, television and various other sources. Because the stocks in the index are chosen to cover a range of industry sectors, it offers greater breadth than the Dow. The problem with using only the S&P 500 as a comparison is that it carries a decidedly large-cap bias, making it inappropriate as a benchmark for small- and mid-cap performance.

The dominance of the S&P 500 has given rise to a plethora of more specialized stock indices, allowing for more precise comparisons within the style of a specific fund. These include the Russell 2000 (focused on small-caps) and the Wilshire 5000 (5000 small-, mid- and large-cap companies, including those in the S&P 500). In the fixed-income arena, the Vanguard Total Bond Index serves as a broad proxy for the bond market. For international-equity funds, the MSCI - EAFE index is commonly used.

Peer Groups as Benchmarks

Yet another method of comparing the returns of your investment portfolio is to use a peer-group comparison approach; that is, comparing your fund's performance against other funds with similar investment styles. Peer-group comparisons are, in many ways, a more realistic measure than indices because they average the performance of other actively managed funds within a given style, rather than the performance of a predetermined group of stocks. Two companies that produce peer-group benchmarks are Lipper and Morningstar. Each benchmark has its own drawbacks, primarily because the "investment objective" of a fund, as reported by mutual fund companies, can be quite vague, combined with the fact that funds may not actually be invested according to the style suggested by the prospectus. This is the number one reason why Morningstar went to its own system of categorization. Lipper shares the same limitations, but a more challenging problem for the individual investor lies in the fact that Lipper dices up the fund universe narrowly, providing too many categories for the average investor to choose from.

Customized Benchmarks

Many professional managers, finding existing benchmarks inadequate proxies for their styles, choose to build customized or blended indices instead. Bond managers have also created customized indices because various bond funds invest in a complex mix of fixed-income sectors and duration ranges not necessarily captured in a single index. Blended indices also work well for hybrid or asset-allocation funds where several asset classes may be at play in a single offering. For example, Fidelity Balanced Fund invests approximately 60 percent of its assets in stocks and other equity securities and the remainder in bonds and other debt securities. It also invests at least 25 percent of total assets in fixed-income senior securities, including debt securities and preferred stock.

It's not unusual to find customized benchmarks in pure-equity environments. For instance, Fidelity uses a host of internally created benchmarks to track its hundreds of funds. The drawback is that customized benchmarks are generally available and useful only to institutional money managers and are not generally found in most publications.

Personal Benchmarks

Of all the benchmarks available, we encourage our readers to use their own "personal benchmark." Simply put, we mean setting a benchmark for the returns you need in order to reach your specific goals, whether it's a long-term goal like retirement, a short-term goal like a new house, or some other aspiration, such as a return five percentage points better than the rate of inflation.

We find this approach to benchmarking most attractive for several reasons. First, it allows an investor to avoid getting too caught up in the short-term mentality that often arises when comparing one's performance to the S&P 500 during any given period. And second, you may be less inclined to worry about whether you should sell a solid, well-diversified fund just because it trailed the S&P by 10 percentage points when its 8 percent net-after-tax gain has put you several steps closer to meeting your investment goals.

Don't Beat Yourself Up

When it comes to selecting and using benchmarks, individual investors should avoid comparing themselves to the top performing "index of the year"-for 1999 and 2003 that index was the Nasdaq Composite, and in 2004 and 2010 it was the Russell 2000. In down years, bond indices take the lead. It's important not to beat yourself up because you did not invest 100 percent of your money in technology or Russell 2000 stocks during those years. Being 100 percent invested only in the strongest performing segment of the market today can lead to disastrous results (think technology bubble).

Often times a good option is to select several benchmarks and examine the performance of individual funds and your overall portfolio on a periodic basis, perhaps annually or semiannually. If you're a growth investor, you may use a widely accepted index like the S&P 500 to get a sense of your performance on the broadest level, but don't stop there. Also compare your portfolio to the appropriate peer-group benchmarks to see how your fund is doing in relation to other similar investments. Finally, and most important, set your "personal benchmark". This benchmark should be modified depending on your changing needs to ensure that your funds are meeting your long-term goals.