You may have heard the term “benchmark” used when reading about investing possibilities or the financial markets. There might be phrases like “returns above the benchmark” or “returns below the benchmark.”
If taken out of context, these expressions may imply that an investment is outperforming or underperforming some other benchmark, but what is that benchmark? For the common investor, what does a stock market benchmark actually mean?
Discover what benchmarks are and how you might benefit from them in your investment endeavors.
What Is a Stock Market Index (Benchmark)?
A market index or benchmark index is a group of representative stocks chosen to be representative of the market as a whole or of a specific asset class. The performance of individual assets or a whole portfolio can be compared to a benchmark.
The Stock Market Benchmark’s History
Charles Dow and Edward Jones invented the first stock market index in 1884. Known as the Dow Jones Transportation index, it followed the fortunes of major railroads as a proxy for the health of the American economy.
The 30 largest industrial corporations that best represent the U.S. economy today are included in this index, which has grown into the Dow Jones Industrial Average, one of the most well-known benchmarks.
In 1923, the Standard Statistics Company established a second classic market index. After only a few years, the firm has created 90 daily-computed indexes.
In time, the Standard Statistics Company morphed into one of Wall Street’s most recognizable institutions: Standard & Poor’s (S&P). S&P Dow Jones Indices is the new name for the corporation after a merger. The S&P 500 composite index is the most extensively used index in the United States.
Benchmarking Types
In the roughly 100 years after its introduction, benchmarks have become an integral cog in the wheel that is the stock market. More on choosing the right benchmark for your purposes will follow. Investors utilize a wide variety of benchmarks, each of which is designed to assess a unique facet of the market. Common examples of benchmarks include:
Focused on Market Capitalization
Some indices’ primary focus is on market capitalization, or the aggregate value of its component stocks. For tracking the performance of companies relative to their market capitalization, four main indices exist:
- Blue Chips
The goal of a blue-chip benchmark is to mirror the performance of the market’s most dominant and profitable firms. These businesses are standard examples of steady profit and sales development that may be anticipated with some degree of certainty.
The Dow Jones Industrial Average is the most widely followed stock market index in the United States. The 30 largest and most successful U.S. public corporations are monitored by the Dow.
- Large-Cap
Stocks in corporations with a market capitalization of $10 billion or more are considered large caps. These corporations are among the largest in the world and are frequently in the forefront of their respective markets.
Stocks of many different types are included in large-cap indexes because they track and measure the performance of very large corporations.
The Standard & Poor’s 500 Index is widely considered the best large-cap stock market index. It follows the 500 largest U.S.-listed firms. It accounts for over 85% of the entire market capitalization in the nation.
- Mid-Cap
Shares of firms with a market capitalization of between $2 billion and $10 billion are considered mid-cap equities. These firms are often in an early stage of development within their markets. Small-cap stocks are less stable than large-cap stocks, but they have the potential for significant development as these businesses expand and improve.
The success of these firms may be tracked by investors using mid-cap indexes, which are composed of a diverse list of them. The Russell Midcap Index, which consists of the 800 smallest businesses in the Russell 1000, is widely used as a benchmark in this space.
- Small-Cap
Stocks from firms with a market capitalization of $0.5 billion to $2 billion are included in small-cap indexes. These businesses tend to be either newcomers or mid-level competitors in niche industries. If you’re an investor, you may use a small-cap benchmark to see how the performance of smaller publicly traded firms compares.
The S&P 600, a small-cap index likewise maintained by Standard & Poor’s, is one of the most widely followed measures of the performance of smaller U.S. corporations.
How to Apply a Benchmark
As a result, benchmarks have developed into extremely useful resources for the investing community. The many applications are as follows:
Index Investing
The widespread use of benchmark index tracking as a proxy for investment activity was inevitable. Index funds, which can be either mutual funds or exchange-traded funds (ETFs), invest in a way that mimics the performance of an index. This type of fund tracks a predetermined index rather than relying on the judgment of a human money manager.
Indexing is a type of investing approach in which these funds play a central role. Heavy diversity is quite beneficial for those investing in the performance of a benchmark index.
When it comes to managing financial portfolios, indexing eliminates a lot of the legwork and tough choices. Investors in an index fund expect the fund’s performance to closely track that of the index it tracks.
Portfolio Performance Evaluation
Benchmarks may also be used to evaluate the efficiency of your investing strategy. You may easily gauge your portfolio’s success by contrasting it to a predetermined standard.
If your investments are focused on technology, for instance, you might want to gauge your success against the Nasdaq. You are doing well if your portfolio is growing faster than the index. If it’s not doing as well as a similar benchmark, you may want to rebalance your portfolio.
Economic Performance Evaluation
A stock market index may be used for more than just tracking the performance of individual stocks. Global market indices are widely used as a barometer of the economy’s health. Since the economy and stock market are so intertwined, this makes sense.
Stock prices often rise during economic expansions. As a counter example, when economic forecasts are gloomy, stock prices often fall. Paying attention to changes in the most widely followed economic indicators can provide insight into the state of any economy.
Determine Market Performance
The stock market usually fluctuates between highs and lows. Using benchmarks, you may get an accurate view of the market and the general mood of the market.
The Standard & Poor’s 500 Index is widely seen as the most representative stock market barometer in the United States. Why? Because it tracks 500 of the biggest publicly listed corporations in the United States, which account for 85% of the total market capitalization of all U.S. companies.
If the S&P 500 Index, a broad measure of the US stock market, is rising, it’s reasonable to infer that stock prices are on the rise, and if it’s falling, you can expect stock prices to be down.
Analyze Previous Results
The past often repeats itself. Even if it’s not always the case, some of the world’s best investors look to their past returns as a guide when trying to forecast what they could achieve in the future.
Keeping tabs on historical benchmarks can provide light on the long-term trends of the index, the typical levels of volatility, and the risks and potential rewards of investing in the market segment represented by the index.
Establish Market Timing
Investors should purchase when fear is high and sell when greed is strong, as famously advised by Warren Buffett. You may use indicators to determine when such sentiments have taken hold of the market.
In order to assist investors in gauging market mood and making informed buying and selling decisions, CNNMoney developed the Fear & Greed Index. You may use the market’s general mood in conjunction with a number of other indicators to help you pace your movements.
Bottom Line
More than a century after their introduction, stock market benchmarks have established themselves as indispensable resources for financial professionals and economists alike. Whether you use a benchmark during portfolio rebalancing or invest directly in index funds, these instruments are crucial to your hunt for stock market success.
