A benchmark is a reference point against which other data are compared. For example, the S and P 500 index is a commonly used benchmark for the performance of many mutual funds that invest in common stocks.
When calculating the rate of return of your (or others') portfolio, you can always say "I made 23% in 2003!" That's great, but the overall market made 26.4% that year, so you kind of fell behind, didn't you? I mean, you could have invested in the S&P 500 on Dec 31, 2002 and sold on Dec 31, 2003 and made over 26% on your money. Instead, all you got was 23%.
This is an example of using a benchmark. It compares how you did against some recognizable standard. If you beat the standard, all kudos to you. But if you trailed it, well, better luck next time.
Of course, you shouldn't look at just one year's worth of returns, but the average returns over a longer time period. You could have been a bit off your game in 2003. In 2004, though, you made 30% while the S&P 500 only did 9.0%. Wow! And over that 2-year period? You did 59.9% overall, versus just 37.8% for the S&P 500. Yay, you!
On an annual basis for those two years, you did 26.4% per year on average, while the S&P 500 did 17.4%. Yay, you, again!
The benchmark, however, should be relevant. If you invest only in large cap companies, for instance, then the S&P 500 or the Russell 1000 are decent choices, while the small cap Russell 2000 would not be a good choice. That would be like comparing the performance of a black lab against that of a Scotty terrier. Just wrong.
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