When researching investment opportunities or financial markets, you often hear something compared to something called a benchmark. You might see statements like “outperforming benchmark returns” or “lagging the benchmark.”
Based on context, we can surmise that these terms mean an investment is performing better or worse than something, but what exactly is that something? What does a stock market benchmark mean for the average investor?
Find out what benchmarks are and how you can use them to your advantage when investing.
What Is a Stock Market Benchmark (Index)?
A stock market benchmark, sometimes called a market index or benchmark index, is a carefully selected group of stocks meant to measure the overall performance of a group of equities or the market as a whole. Benchmarks are used as a standard or baseline against which specific investments or a portfolio’s performance can be measured.
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History of the Stock Market Benchmark
The first market index was created by Charles Dow and Edward Jones in 1884. The index was called the Dow Jones Transportation index and tracked the performance of the large railroad companies that were seen as a reflection of the United States economy at the time.
That index evolved to become one of the best-known benchmarks, the Dow Jones Industrial Average, which today includes 30 of the largest industrial companies that represent the U.S. economy.
Another classic market index was created by the Standard Statistics Company in 1923. Within a few years, the company developed 90 indexes that would be computed on a daily basis.
The Standard Statistics Company evolved to become one of the biggest names on Wall Street: Standard & Poor’s, or S&P. Through a merger, the company’s name recently changed once again to S&P Dow Jones Indices. The company’s flagship index, the S&P 500 composite, is the most widely used benchmark in the U.S. today.
Types of Benchmarks
Over the past century or so, benchmarks have become a crucial part of the complex machine that is the stock market. However, it’s important that you use the appropriate benchmark for what you plan to measure and compare — more on this later.
There are several types of benchmarks investors use, each measuring different market segments. The most common types of benchmarks are:
Market Capitalization-Focused
The central theme to some indexes is market cap, or size of the constituents listed within it. There are four primary types of market-cap-focused indexes:
1. Blue Chips
A blue-chip benchmark is designed to track the results of the largest, most successful companies on the market. These companies are known for producing relatively predictable gains and revenue growth.
The flagship blue-chip index in the United States is the Dow Jones Industrial Average. The Dow tracks 30 of the largest and most successful publicly traded companies in the U.S.
2. Large-Cap
Large-cap stocks represent companies worth $10 billion or more. These are some of the largest companies in the world and tend to be leaders within their respective industries. Large-cap indexes list a diverse group of stocks in this category, tracking and measuring the performance of very large companies.
The most popular large-cap index is the S&P 500, which tracks the 500 largest publicly traded companies in the U.S. It represents around 85% of the country’s total market cap.
3. Mid-Cap
Mid-cap stocks represent companies worth between $2 billion and $10 billion. These companies tend to be just finding their footing in their respective industries. They’re not quite as predictable as large-cap stocks, but offer the potential for meaningful growth as these companies continue to grow and evolve.
Mid-cap indexes are made up of a diversified list of these companies, giving investors the ability to track the performance of mid-sized companies.
One of the most popular benchmarks in this category is the Russell Midcap Index, which is made up of the 800 smallest companies on the Russell 1000.
4. Small-Cap
Small-cap indexes include stocks representing companies worth between $500 million and $2 billion.
These companies are often in the beginning to intermediate stages of business, or may be experienced players in relatively small markets. A small-cap benchmark shows investors how smaller publicly traded companies are faring.
One of the most popular small-cap indexes is the S&P 600, the small-cap index also maintained by Standard & Poor’s that includes 600 smaller U.S. companies..
Sector-Focused
There are several sectors across the stock market. Some of the most popular include technology, biotechnology, energy, and consumer goods. Each sector is represented by a long list of benchmarks.
One of the best examples of a sector-focused index is the Nasdaq. Known as a tech-heavy index, a large percentage of its constituents are within the technology and biotechnology sectors.
Strategy-Focused
Some indexes have a central focus on an investment strategy. These usually fall into one of the following categories:
- Growth Stocks. Growth-focused indexes track a diversified group of stocks known for producing compelling revenue, earnings, and price growth. One of the most popular in this category is the Russell 3000 Growth Index.
- Value Stocks. Value-focused indexes track a diversified group of stocks that are believed to be undervalued when compared to their peers. Investors believe that by investing in these stocks, they’ll outperform the market as the stocks recover from recent lows. One of the most popular in this category is the S&P 500 Value Index.
- Income Stocks. Income-focused indexes track stocks known for paying the highest dividends. One of the most popular benchmarks in this category is the S&P 500 Dividend Aristocrats.
Asset Class Focused
Stocks aren’t the only asset class on the market, nor are they the only class of assets with a benchmark index to track them. Indexes exist to track bonds, commodities, futures, and more. If it’s an asset class, there’s likely an index that covers it.
A great example of indexes in this category is the S&P U.S. Treasury Bond Index, which tracks the performance of a highly diversified group of bonds issued by the U.S. Treasury.
Risk-Focused
Risk-focused indexes are largely used to determine the level of volatility and variability in the market, helping investors understand what they’re up against in the battle between the bears and bulls.
One of the most popular risk-focused indexes is the CBOE Volatility Index (VIX).
How to Use a Benchmark
Benchmarks have become incredibly valuable tools for investors. Here are the different ways to use them:
Index Investing
With so many people tracking benchmark indexes, it was only a matter of time before they were used as investments themselves. These days, there’s a long list of index funds, which are mutual funds or exchange-traded funds (ETFs) that make investments that track the movement of an underlying index. These funds are based on an underlying index instead of the investment decisions of a fund manager.
The index investment strategy (indexing) is centered around investing in these funds. Individuals investing in a benchmark index’s performance benefit greatly from heavy diversification. Indexing removes much of the research and decision-making from the process of managing investment portfolios. Index investors know the fund’s performance is likely to be very similar to that of the underlying index.
Measure Portfolio Performance
Another common use for benchmarks is to measure the performance of your investment portfolio. All you need to do is compare your portfolio’s performance to the appropriate benchmark to see how well you’re stacking up.
For example, if your portfolio is tech-heavy, consider comparing your performance to that of the Nasdaq. If your portfolio is outpacing the index, you’re in good shape. If it’s underperforming a comparable benchmark, it’s time to adjust your holdings because there’s more money to be made elsewhere.
Gauge Economic Performance
Stock market indexes aren’t just a tool for understanding the performance of different segments of the market. Widespread benchmarks that focus on the market as a whole also tell you quite a bit about the state of the economy.
After all, the economy and equities market are closely correlated.
When economic conditions are good, stocks tend to be up. Conversely, when economic conditions look grim, stocks tend to be down. Paying attention to the movement in the largest flagship benchmarks for any economy will paint a picture of that economy’s health.
Gauge Market Performance
The stock market is known for moving through a series of peaks and valleys. Benchmarks can be used to give you a clear picture of the market and market sentiment.
In the U.S., the best benchmark for this is the S&P 500 index. That’s because the index lists 500 of the largest publicly traded companies in the U.S., representing 85% of the country’s market cap.
With such a large representation of the domestic market, when the S&P is up, you can safely assume that stocks are generally trending in the upward direction, and vice versa.
Measure Historical Performance
History tends to repeat itself. Although past performance isn’t always indicative of future results, the world’s most successful investors often use historical performance as a way to predict the returns they may generate.
Tracking benchmarks throughout history gives you an idea of how the index has performed over time, the levels of volatility generally experienced, and the risk and reward associated with investing in the section of the market measured by the index.
Determine Market Timing
Warren Buffett famously told investors to buy when fear is high and sell when greed sets in. Benchmarks can tell you when those emotions are taking hold in the market.
CNNMoney created the Fear & Greed Index to help investors measure market sentiment when determining the best time to buy and sell stocks. Many other benchmarks can also be used to determine market sentiment to help you decide when to make your moves.
Final Word
Stock market benchmarks have been around for more than a century and have proven to be valuable tools for investors and economists alike. Whether you compare your portfolio to a benchmark during rebalancing or invest directly in index funds, these tools are integral in the search of stock market success.