Benchmarks can be defined as a point of reference for measurement. Stock market benchmarks are used by individual investors, financial advisors, portfolio managers, and market researchers to determine how a particular market or market sector performs. Market indices can be especially useful for advisors and their clients by offering market standards to help them to determine the relative performance of their clients' investments. It's essential to compare those investments to the index that best tracks securities comparable to a portfolio's holdings.
Suppose you own investments characterized as intermediate bond, large-cap growth, and international. What are the most important benchmarks? The S&P 500 might make sense for the large-cap growth fund, but the Russell 1000 Growth Index would be even more appropriate, as it tracks only growth companies, while the S&P 500 includes both growth and value companies.
For the bond investment, your advisor would likely consider the Lehman Brothers Aggregate Bond Index, which is a combination of multiple bond benchmarks and is generally considered the best proxy for the overall market.
For the international investment, the most widely accepted proxy is the Morgan Stanley Capital International Europe Australasia and the Far East (MSCI EAFE). The EAFE is composed of multiple indices representing each of these regions. Of course, if your international investment is concentrated in one particular region, like Europe, your advisor would ideally use a benchmark specific to that region only.
Benchmarks can range from broad to highly specific. The most important factor in choosing benchmarks for performance measurement is that they approximate your actual holdings as closely as possible. Otherwise their efficacy is limited.
It may be useful to construct a custom-blended benchmark. Assuming the same three holdings as above, we can create a benchmark that actually tracks the Russell 1000 Value, the Lehman Aggregate Bond, and the EAFE in the appropriate percentages as determined by your actual holdings. Your account's performance relative to this blended benchmark may help reveal how your total portfolio is performing relative to a broad market benchmark.
