A benchmark is a standard or base used to compare the allocation, risk and return of a portfolio. The comparison can be for any period. Typically, benchmarks are represented by indices in the form of ETFs or mutual funds that represent an asset class.
Asset classes represented by benchmarks can be broad ones, such as the Russell 1000 or something much more specific like U.S. small cap growth stocks or even a combination of two or more.
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The Role Of Risk
Portfolios are usually diversified, containing several asset classes to help mitigate risk. It’s important to keep this in mind because a meaningful benchmark should be as diversified as the portfolio it is being used to evaluate.
This is worth noting because many people try to use a single asset class or index, like the Standard & Poor’s 500 index to compare against a totally unrelated diversified portfolio. Comparing the performance of that portfolio against, for example, the S&P 500 is meaningless or, worse yet, misleading.
Variability And Volatility
Volatility measures the size of the change in the value of a portfolio. Variability measures the frequency of change in value. Risk increases with an increase in either variability or volatility or both. Standard deviation measures volatility. The higher the standard deviation, the more volatility and therefore the greater the risk.
Beta is used to measure volatility against a benchmark. A beta above 1 shows more up and down movement than the benchmark. A beta below 1 has less up and down movement than the benchmark. The Sharpe ratio measures risk-adjusted return. The Sharpe ratio represents the average return earning above a risk-free investment, such as a U.S. government bond. A high Sharpe ratio indicates a superior risk-adjusted return. Many investment websites, including FinanceBoards provide measures of standard deviation, beta and Sharpe ratio.
Risk Profile And Benchmarks
To help you decide on an appropriate benchmark, you need to measure your risk profile. If you are willing to take a moderate amount of risk, an allocation that includes 50-60% equities would be an appropriate benchmark.
Once you’ve established your risk profile and settled on a benchmark, your next step is to select investments (stocks, bonds, ETFs, mutual funds) and allocate them by asset class to your portfolio. Then it’s simply a matter of comparing the risk and return of your portfolio to your chosen benchmark.
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Overall benchmark return is calculated by multiplying the return of each component by its weighting. If your benchmark components had returns of 10%, 5% and 4% with weightings of 50%, 30% and 20% respectively, your benchmark return would be 5% plus 1.5% plus 0.8% for a total return of 7.3%.
Compare that return to the return on your existing or proposed portfolio. You can measure risk by comparing beta and standard deviation. You may decide that you are taking too much risk (or too little), in which case you can adjust your portfolio accordingly. At the end of the day, intelligent investing is about managing risk in a way that matches your personal risk profile.