What is a benchmark and how is one chosen?

A benchmark is a reference — usually an index — against which the performance of a portfolio or fund is measured. It answers the question behind every return figure: compared with what? A return of 8% is excellent in a year in which comparable investments returned 3%, and disappointing in one in which they returned 20%.

For a private investor, the benchmark is best thought of as the simple alternative: what the money would have earned in a cheap, passive investment with a similar mix of assets.

What makes a benchmark fair

A good benchmark has the same broad exposure as the portfolio it is compared with. It should be:

Representative: covering the same asset classes, regions and types of company as the portfolio.
Investable: something that could actually be bought, for example through an index fund.
Chosen in advance: before the results are known, not afterwards.
Measured the same way: in the same currency, and as a total return with dividends reinvested.

Blended benchmarks

A portfolio that mixes asset classes needs a benchmark that mixes them in the same proportions. Its return is the weighted average of the component indices:

R_{\text{benchmark}} = \sum_k w_k \, R_k

where $w_k$ is the target weight of asset class $k$ and $R_k$ the return of its index.

A simple illustration

A portfolio holds about 70% global stocks and 30% euro government bonds. In a year in which a world equity index returns 12% and a euro government bond index returns 2%:

R_{\text{benchmark}} = 0.7 \times 12\% + 0.3 \times 2\% = 9\%

If the portfolio returned 10%, it beat its fair benchmark by one point. Compared with the world equity index alone, it would seem to have lagged by two points — an unfair comparison, because almost a third of it was never invested in stocks.

Common mistakes

Comparing with the wrong market: a European portfolio against the S&P 500, or a portfolio with a large cash share against a pure stock index.
Price index against total return: comparing a portfolio that received dividends with a price index flatters the portfolio.
A currency mismatch: an index measured in US dollars differs from the same index in euros by the exchange-rate move.
Changing the benchmark afterwards to whichever makes the results look best.
Ignoring cash flows: deposits and withdrawals distort a simple comparison. The time-weighted return is the right figure to set against an index.

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