Benchmark

Refers to a metric that institutional and individual investors use to assess the risk and return of a portfolio and gauge its performance.

Author: Chadi Kattoua
Chadi Kattoua
Chadi Kattoua
I hold a Master's in Business Data Analytics and a Bachelor's in Finance. I serve as a Techno-Functional Consultant within financial technology, specializing in delivering comprehensive solutions for banks in trade finance and associated software platforms. Concurrently, I contribute as a part-time Data Scientist and Data Strategy Consultant. Additionally, my skill set encompasses a solid background in financial research analysis, further enhancing my capabilities in the dynamic intersection of finance and technology.
Reviewed By: Isabel Lin
Isabel Lin
Isabel Lin
Isabel Lin is a Computer Science and Economics student at Brandeis University, set to graduate in 2026. At Wall Street Oasis, Isabel progressed from a Financial Research Intern to an Editor Specialist, demonstrating her ability to analyze and communicate complex financial information effectively. In addition to her academic and professional endeavors, Isabel has achieved notable success in athletics and music, being a U.S. Junior Olympic National Gymnast and a Carnegie Hall Pianist. These accomplishments reflect her discipline and versatility, which she brings to her work in financial markets and computing.
Last Updated:September 27, 2023

What Is A Benchmark?

A benchmark is a metric that institutional and individual investors use to assess the risk and return of a portfolio and gauge its performance.

In other words, it is a reference point that may be used to assess the performance of:

  • Security
  • Mutual fund
  • Investment manager 

For this reason, broad market and market-segment stock and bond indexes are typically utilized. It is a component of a black belt in Six Sigma.

Here are some widely recognized benchmarks commonly used for thorough analysis:

There are indexes for every kind of asset class. The S&P 500 and Dow Jones Industrial Average are two of the most widely used large-cap stock indexes in the equities market.

Choosing and establishing a benchmark may be a crucial component of investing for individual investors. 

Additionally, conventional ones indicate general market traits like large-cap, mid-cap, small-cap, growth, and value. Investors may also locate indices based on market trends, sectors, dividends, fundamental qualities, and various other factors.

Investors can find suitable investment funds and express their investment goals and expectations to a financial adviser if they know or are interested in a particular form of investment.

Key Takeaways

  • Benchmarks are reference points used to assess portfolio risk, return, and performance.
  • Incorrect benchmark selection can lead to flawed results in portfolio analysis.
  • Effective benchmark usage involves proper portfolio selection, asset allocation consideration, and comparison to benchmark performance.
  • Risk indicators like Standard Deviation, Beta, and Sharpe Ratio help manage portfolio risk and returns.
  • Widely used indexes like S&P 500, DJIA, and Nasdaq 100 provide insights into market and investment performance.

What is a Benchmark Error?

This error occurs when an incorrect benchmark is chosen for a model, and the outcomes of that model will be flawed.

By choosing the most appropriate one, this mistake may be readily avoided and result in significant dispersions in an analyst's data.

In building a market portfolio using the capital asset pricing model, selecting the most appropriate benchmark or market in your calculations is crucial to prevent mistakes (CAPM).

Analysts should value the selection of suitable benchmarks. To determine if their portfolio is performing in line with their expectations, they should closely monitor their investment portfolios based on a criterion.

The performance may show that there has been style drift if it deviates noticeably from the original planned risk tolerance and approach.

Investors can choose from a variety of criteria nowadays. Several were developed for stocks, fixed income, hedge funds, derivatives, real estate, and other financial instruments.

Those criteria bring investors and analysts to the significance of comprehending which index best suits their investments; for example, if your portfolio is heavily weighted in technology, you should utilize the Nasdaq rather than the S&P 500. 

Thus, this error occurs when the incorrect assessing model is chosen in financial investment, leading to misleading outcomes.

How to use a benchmark to Measure the Performance of a Portfolio?

A good one should match the anticipated rewards. Consequently, some benchmarks will be suitable for some portfolios while, at the same time, being unsuitable for other portfolios. The S&P 500, which includes large-cap US equities, is one example.

The stages involved in appraising one are as follows:

1. Pick a portfolio to be evaluated

The selection of the portfolio or account whose performance will be evaluated comes first. It might be a single investment account, a whole portfolio of investments, or a group of accounts. 

For instance, investing, retirement, and college savings accounts might all be included in a portfolio.

2. Take into account the asset allocation

The portfolio's or account's asset allocation is the subject of the next phase. The investments can be divided into:

  • US stocks with big and small caps
  • Foreign equities from developed and developing nations
  • US bonds
  • Real estate
  • Cash

For instance, a college savings account's asset mix may be comprised of 80% large-cap US equities, 10% developed-country overseas stocks, 5% real estate, and 5% US bonds.

3. Determine the most relevant benchmarks, then evaluate the portfolio's actual performance against them

Investors anticipate that their portfolio will perform in a way that satisfies both their risk tolerance and projected returns. 

The investor wants to know if the portfolio generated the expected returns as agreed upon with the portfolio manager when comparing the actual performance against the benchmark performance.

Managing Investment Portfolio using benchmark values of risk indicators

Diversifying their portfolio is one strategy investors take to control risk. They achieve diversification by including several asset classes, including stocks, bonds, and gold. 

Additionally, because higher risk has a more significant potential return than lower risk assets, most investors seeking long-term returns are ready to spend more significantly on them.

The magnitude of portfolio value changes also measures volatility. The magnitude of portfolio value changes gauges volatility. The volatility of investment funds that hold commodities, whose values fluctuate more widely, is higher. 

On the other hand, variability quantifies how frequently a value changes. In general, the danger increases with the amount of unpredictability.

Investors can assess the riskiness of assets using a variety of risk measures. Risk measures can be employed to comprehend better the risks associated with these investments. 

Primary Risk Indicators

Standard DeviationBeta, and Sharpe Ratio are investors' three primary risk indicators.

1. Standard Deviation

Standard deviation is a metric used in finance that reveals the historical volatility of an investment by comparing it to its yearly rate of return.

A higher standard deviation indicates greater volatility and, hence, a greater chance of loss.

The square root of a number obtained by comparing data points to a population's overall mean is used to compute the standard deviation. 

A low standard deviation indicates that the values are often close to the mean, whereas a significant standard deviation indicates that the values are much outside the mean.

Consider data points 1, 2, 3, and 4. 

The mean is (1+2+3+4)/4 = 2.5. 

The average of mean differences = [(1-2.5)^2 + (2-2.5)^2+ (3-2.5)^2 + (4-2.5)^2]/4 = 1.25. 

The standard deviation = √1.25 = 1.118

2. Beta

Beta calculates the portfolio's systematic risk by calculating the volatility of the portfolio relative to a certain benchmark. 

An investment is deemed less volatile than one if its beta value is less than one.

If it has a beta of 1, it implies that the risk and reward are directly correlated, meaning that the greater the risk, the greater the profit.

It is regarded as aggressive and hence more volatile than the benchmark if the beta value is larger than one.

When it changes, a beta of 1.1 is predicted to move 10 percent more than the benchmark, either up or down.

3. Sharpe Ratio

The Sharpe ratio corrects a portfolio's historical or anticipated future performance for the excess risk.

A high Sharpe ratio is favorable compared to similar portfolios or funds with lesser returns. However, the assumption that returns are regularly distributed is one of the Sharpe ratio's many flaws.

Examples of different benchmarks in stock market

Analysts use wide indexes to assess both the performance of the markets and their performance as investors. 

When stockholders want to know "where the market is," they look to indices like the S&P 500, the Dow Jones Industrial Average (DJIA), and the Nasdaq 100

Financial media sources worldwide display the values of these indices daily.

1. S&P 500

One of the top index providers and sources of independent credit rating data is Standard & Poor's (S&P).

One of the most prominent credit rating organizations, Standard & Poor's, assigns letter grades to businesses, nations, and the debt they issue on a scale from AAA to D, reflecting the level of investment risk.

The well-known S&P 500 Index is maybe Standard & Poor's most well-known item.

Numerous assets, such as futures contracts, mutual funds, and ETFs, are based on the S&P 500.

2. U.S Treasuries

Given that the U.S. government stands behind them with its full faith and credit, Treasury securities are among the safest investments.

According to the maturity period, Treasury securities are separated into three major groups:

You may buy any of these Treasury securities directly from the United States government on the website or by using a bank or broker.

Despite being low-risk, treasuries still have some hazards, such as being affected by inflation and interest rate changes. In addition, treasuries have low returns because they are a secure investment. Federal taxes must be paid on interest received on Treasury securities.

3. Exchange Traded Funds (ETFs) 

ETFs are used to compare the relative performance of the bond or fixed-income market.

A stock, commodity, bond, or foreign currency exchange-traded fund, or ETF, is a type of financial vehicle. An ETF is exchanged at varying values throughout the trading day, much like a stock.

It is simple to buy and sell their shares or interests on the secondary market.

Researched and authored by Chadi Kattoua | LinkedIn

Reviewed and Edited by Aditya Salunke | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: