Please ensure Javascript is enabled for purposes of website accessibility

What Is a Benchmark?

By Jason Hall – Jun 22, 2015 at 8:03PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

The word "benchmark" gets thrown around a lot in the financial media, yet many people don't know the definition of a benchmark. Let's go over what it means and how investors can put this concept to use.


Originally a surveying term, "benchmark" has evolved into financial speak for a standard by which performance is measured. Photo: Flickr user Travis White.

Benchmark definition
According to Merriam-Webster, the literal definition of a benchmark is "something that can be used as a way to judge the quality or level of other, similar things." But in the world of investing, it refers to a standard against which an investment's performance is measured.

There are a number of commonly used benchmarks in investing, but most are indexes, like the S&P 500 (^GSPC 1.97%), the Dow Jones Industrial Average (^DJI 1.88%), and the Russell 1000. These indexes are lists of stocks that are grouped together based on certain criteria -- most often the underlying companies' size and/or industry. The idea behind an index is to create a standard for gauging the performance of the market (or a particular sector of the market) and comparing the returns of individual investments.

Choosing the right benchmark 
Mutual funds and ETFs will typically give you historical performance against the appropriate benchmark based on the goals, makeup, and objectives of the fund. Stock returns are often compared to the S&P 500, which is a broad-based index of U.S.-based blue-chip stocks. As a general measure, the S&P 500 is an appropriate benchmark for gauging the performance of your holdings and the stocks you're interested in buying.

But it's important to keep in mind that you can't compare every investment to the world's most popular benchmark index.

If you were comparing the total returns of, say, the PIMCO Total Return R fund to the S&P 500, you'd think that fund was a terrible investment:

^SPXTR Chart

However, the PIMCO Total Return fund is a bond fund, and the S&P 500 is a broad index of stocks, which are not a comparable investment. Sure, the S&P 500 has much higher total returns than the Total Return fund, but investors in a bond fund aren't trying to beat the market, but rather to preserve capital and avoid the sudden declines in value that stocks can experience (see the sharp drop in the blue line within the gray block, which represents the most recent U.S. recession).

To start, the best use of a benchmark index is to measure the individual performance of its components against the whole. For example, here's how well-known S&P 500 component Wells Fargo & Co has performed against the index since 2000:

^SPXTR Chart

What makes the S&P 500 an appropriate benchmark for many stocks? As a starting point, it's very broad-based. According to S&P, about 80% of the U.S. stock market's value is reflected in the S&P 500 components. On the other hand, if one were looking at a much smaller bank like BofI Holding, then it's worthwhile to compare it to a small-cap index like the S&P SmallCap 600:

BOFI Total Return Price Chart

But even then, the S&P 500 isn't necessarily inappropriate, as it offers a look at the stock's performance versus what a large portion of the market delivers -- a target that the average investor should expect to match, if not beat. 

Portfolio management and measuring your performance 
If you're picking your own stocks, or even a basket of mutual funds, it's important to measure how you're doing over long periods of time. There are two key reasons: 

  1. Measuring your returns against a benchmark will help you make sure you're on track to reach your financial goals, like retiring in comfort or paying for a kid's college education. 
  2. If you're not performing as well as a benchmark (like the S&P 500 or Russell 1000), then you can re-evaluate your investing decisions in order to improve your returns. 

Let me stress this: Short-terms returns (both strong and poor) can be misleading. Benchmarks are best used to evaluate returns over multiple years. Measuring your investments' performance every day, or even every month, is a recipe for emotional, overly active trading.

Don't mistake past performance for future results 
While great companies have a habit of continuing to be great, don't make investing decisions based solely on a company's past history of outperforming or underperforming its benchmark.

Such comparisons can help inform your decision, but they shouldn't be the decision-makers. It's even more important that you understand the company as it is today, and if you choose to invest in a company, make the decision based on the company's merits -- i.e., whether or not it is built for success -- not how much it outperformed its benchmark last year. 

Jason Hall owns shares of BofI Holding and Wells Fargo. The Motley Fool recommends BofI Holding and Wells Fargo. The Motley Fool owns shares of BofI Holding and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Dow Jones Industrial Average (Price Return) Stock Quote
Dow Jones Industrial Average (Price Return)
^DJI
$29,683.74 (1.88%) $548.75
S&P 500 Index - Price Return (USD) Stock Quote
S&P 500 Index - Price Return (USD)
^GSPC
$3,719.04 (1.97%) $71.75
Wells Fargo & Company Stock Quote
Wells Fargo & Company
WFC
$40.81 (1.95%) $0.78

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
327%
 
S&P 500 Returns
105%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 09/29/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.