What is a Benchmark?
A benchmark is a measure used by individual and institutional investors to analyze the risk and return of a portfolio to understand how it is performing vis-à-vis other market segments. Some of the established benchmarks for standard analysis include the S&P 500, Barclays US Aggregate Bond Index, Russell 2000, and the S&P United States REIT for real estate. Investors assign the benchmarks to the portfolio manager, who uses them to compare the performance of the portfolio and make investment decisions with the expected performance in mind.
- A benchmark is a measure used to analyze the performance of a portfolio compared to the performance of other market segments.
- Some of the established benchmarks include the Dow Jones Industrial Average, Russell 2000, and the S&P 500.
- The selected benchmark should correspond to the investment style of an investor and the expected return of a benchmark.
Benchmark of a Portfolio
A good benchmark should correspond to the investment style of an investor and the expected returns from the portfolio. It means that certain benchmarks will be appropriate for certain portfolios, while, at the same time, being inappropriate for other portfolios. For example, the S&P 500 can be used as a benchmark for a portfolio comprising large-cap US stocks.
However, the S&P 500 will not be an appropriate benchmark for measuring a portfolio investing in international stocks in emerging markets. It is because the benchmark may produce information that is misleading to the investor and the portfolio manager.
The most popular benchmarks for measuring the risk and return of a portfolio are market indexes such as the Russell 1000, Russell 2000, the Dow Jones Industrial Average, and the S&P 500. There are other indexes that are specific to the industry, security classes (such as small-cap growth stocks), and other market segments. An alternative is to use other portfolios to establish benchmarks that will be used to measure the performance of the portfolio.
How to Use a Benchmark to Measure the Performance of Portfolio
The following are the steps involved when evaluating the performance of a portfolio against a benchmark:
1. Choose portfolio to be measured
The first step is to choose the portfolio or account whose performance is going to be measured. It can be a single investment account, an entire investment portfolio, or a collection of accounts. For example, an entire investment portfolio may include investment accounts, retirement accounts, and college savings accounts.
2: Consider the asset allocation
The next step is to consider the asset allocation in the portfolio or account. The investments may be categorized into large-cap and small-cap US stocks, international stocks (developed and emerging countries), US bonds, real estate, and cash. For example, the asset allocation of a college-savings account may include 60% large-cap US stocks, 20% international stocks (developed countries), 10% real estate, and 10% US bonds.
3: Identify appropriate benchmarks
The third step involves choosing an appropriate benchmark that will be used to compare the performance of a portfolio. When choosing a benchmark, you should match the asset classes in the portfolio to an appropriate benchmark. For example, you can use S&P 500 as a benchmark in a portfolio with a majority of large-cap US stocks.
However, the S&P 500 may not be ideal for measuring the performance of bonds and real estate that are added in the portfolio as a layer of safety. Bonds can use the Bloomberg Barclays Aggregate index as a benchmark, while real estate can be measured against the S&P US REIT or the S&P Global REIT.
4: Calculate actual performance vs. benchmark portfolio performance
The last step is to calculate the performance of the portfolio and compare it to the performance of the benchmark. The expectation of the investor is that the portfolio will perform in a way that it meets their expected returns, as well as the risk tolerance. When comparing the actual performance versus the benchmark performance, the investor wants to determine if the portfolio earned the expected returns as agreed with the portfolio manager.
Managing Risk in a Portfolio Investment
One of the ways that investors use to manage risk is to diversify their portfolio. They do the diversification by including different types of asset classes such as equities, stocks, and bond. Also, most investors who are looking to get returns in the long term are willing to invest more heavily in higher-risk investments. Investors can use various risk metrics to determine the riskiness of the investments. The main risk metrics used by investors include standard deviation, beta, and Sharpe Ratio.
1. Standard Deviation
Standard deviation measures the volatility of a portfolio during a given period of time. An investment with a higher standard deviation has higher volatility and therefore, greater risk of loss.
Beta measures the systematic risk of a portfolio by determining the volatility of the portfolio in relation to a particular benchmark. If an investment has a beta of less than one, it is considered to be less volatile than one. If the investment has a beta of one, it means that there is a direct correlation between the risk and the reward of the investment, i.e., the higher the risk, the higher the reward. If the beta is greater than one, it is considered to be aggressive, and therefore more volatile than the benchmark. When using beta as a measure of risk, we use the S&P 500 as the benchmark.
3. Sharpe Ratio
The Sharpe ratio is commonly used as a measure of risk-adjusted return. It shows the amount of excess return that an investor will receive for the extra volatility of a riskier asset. When calculating the Sharpe ratio, an investor can use the projected performance of the portfolio and the risk-free rate. The ratio can help an investor determine the highest return than an investment will earn while considering the risk involved.
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