A benchmark is a standard or measure that is used to compare the allocation, risk, and return of a given portfolio. The comparison can be for almost any period.

What's in a Benchmark?

Benchmarks usually include unmanaged indices, Exchange Traded Funds (ETF) or mutual fund categories to represent the various investment asset classes, rather than individual investments. The asset classes in a benchmark can include broad measures, such as the Russell 1000, or specific asset classes, such as U.S. small cap growth stocks, high-yield bonds or emerging markets. Or a combination of the two.

Risk

To help manage risk, most people invest in a diversified portfolio that includes numerous asset classes, including U.S. equities, non-U.S. equities and bonds. Thus, if a benchmark is going to provide a meaningful comparison, it should also be similarly diversified. Yet, many people persist in comparing the return of a diversified portfolio against a single asset class or index, such as the S&P 500.(See also: The Importance of Diversification.)

Risk includes both variability and volatility. Volatility is measured by the size of the change in portfolio value. Investments, for example, commodities which have larger moves up and down in value, increase the volatility. Variability measures the frequency of the change in value. The more variability, the greater the risk.

Measures of Risk

Several measures are used to evaluate portfolio risk and reward including standard deviation, Beta and Sharpe ratio.

  • Standard deviation is a statistical measure of volatility. A higher standard deviation indicates more volatility and greater risk.

  • Beta is used to measure volatility against a benchmark. For example, a portfolio with a beta of 1.2 is expected to move 120%, up or down, for every change in the benchmark. A portfolio with a lower beta would be expected to have less up and down movement than the benchmark.(See also: Understanding Beta.)

  • The Sharpe Ratio is a widely used measure of risk-adjusted return. The Sharpe ratio is the average return earned in excess of a risk-free investment, such as a U.S. government bond. A higher Sharpe ratio indicates a superior overall risk-adjusted return.

These measures can be obtained from many investment websites.

Benchmarking

To help determine an appropriate benchmark you need to first measure your risk profile. For example, if you are willing to take a moderate amount of risk (your profile is a 6 on a scale of 1-10) an appropriate benchmark could be a 50-60% equity allocation that includes:

  • 55% of the Russell 3000, which is a market capitalization-weighted index that includes large, mid and small-cap U.S. stocks.

  • 40% of the Barclays Aggregate Bond Index which includes U.S. investment-grade government and corporate bonds.

  • 15% of MSCI EAFE, which is an index that tracks the performance of 21 international equity markets including Europe, Australia and Southeast Asia.                                                                                     

Portfolio Vs. Benchmark

Once you've established your risk profile and settled on an appropriate benchmark you then need to construct a portfolio by selecting investments—individual stocks, bonds, ETFs or mutual funds, and allocate them to the various asset classes. For example, 15% in non-U.S. equities and 25% in U.S. investment grade corporate bonds.  

You can then compare the risk and return of your portfolio to the benchmark.

  • Returns are calculated by multiplying the return of each component by its weighting. For example, if the Russell 3000 had an 8% return, the Barclays US Aggregate a 3% return and the EAFE a -2% return; the weighted benchmark return would be .55 times 8%, .4 times 3% and .15 times -2% or 4.4% plus 1.2% less .3% for an overall return of 5.3%.

  • The risk is measured by comparing Beta and standard deviation.

If you have an existing portfolio, you can compare it to various benchmarks to evaluate the risk and return.

Based on the measures against the benchmark — are you taking too much or too little risk, etc.—you may need to make changes to your portfolio that include replacing investments, adding asset classes to provide greater diversification and/or adjusting your overall asset allocation.

The Bottom Line

Investing is about managing risk. Generally, a portfolio with more risk should also offer the potential for a higher long-term return. The goal is to construct a diversified portfolio that matches your risk profile and provides a favorable risk-adjusted return, as measured by the Sharpe ratio. 

 

 

 

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