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In investing, generating positive returns is essential. Using a benchmark to evaluate your performance can help you figure out how much of your total return comes from your own individual investment decisions rather than simply from the movements of the financial markets overall. Most mutual funds and exchange-traded funds use benchmarks to measure their relative performance, and experienced individual investors often choose a benchmark as a standard for evaluating their success in choosing stocks and other investment securities.
Benchmarks and active investing
Ever since stock market indexes have existed, investors have used them as benchmarks against which to monitor their own performance. The Dow Jones Industrials, for example, has existed for more than a century, and you can find total return data on the stocks in the Dow going back throughout its history.
The advent of passive index investing in the 1970s greatly increased the importance of using benchmarks as a standard of performance. Index funds made it possible for investors to track major market benchmarks like the S&P 500 extremely closely, with only minimal underperformance that reflected the operating costs of running the fund. Thereafter, because investors always had a low-cost option to track a market index closely, the rationale for using active management strategies was that they expected to outperform the relevant benchmark index. The higher expenses associated with most active strategies make it more difficult for the average fund to outperform the market, but some have demonstrated long track records of success in doing so.
The right benchmark for the right strategy
Many benchmarks exist covering a wide range of investments. The Dow and S&P 500 are often used as benchmarks for assessing stock portfolios, but their bias toward large-cap stocks makes them less ideal for those who invest primarily in smaller companies. Many use small-cap indexes like the Russell 2000 to assess small-cap portfolios, and similar indexes exist for international stocks. For bonds, the Barclays Aggregate Bond Market Index incorporates different types of bonds into a single benchmark.
You can often find more narrowly tailored benchmarks for different investing strategies. For instance, if you gravitate toward a particular sector of the stock market, then sector-based indexes can give you an idea whether your stock selection is adding value compared to an index-based approach. Bond indexes focusing on Treasury bonds, investment-grade corporate bonds, and junk bonds can give you more detailed data on your performance if you specialize in certain bond investments or simply want to break down your portfolio in more detail.
Using a benchmark is critical to help you draw the right conclusions from your investment choices. If you consistently underperform your benchmark, then there's no shame in using index funds to capture the market's better returns.
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