Why Care About Benchmarks?

Financial newscasters constantly talk about benchmarks, telling us about the performance of the Dow Jones Industrial Average, the S&P 500 or the Nasdaq Composite Index. Why should we care about these indices? Are they important to our own financial portfolios?

Professional money managers of U.S. large-cap portfolios typically focus on the S&P 500 Index. It includes the 500 largest stocks in the U.S. by market capitalization (the number of shares of a company multiplied by its stock price). The Dow holds only 30 stocks, so the S&P 500 is a much wider measure of the economic status of the U.S. market. According to S&P Global, over 7.8 trillion U.S. dollars are benchmarked to the S&P 500 index.

So how can we use this information? Remember when you were back in high school, and there was a smart kid in your class that everybody got measured against? If the smart kid got a B on a really hard test, then it was a cause for celebration if you got an A. The S&P index works in a similar way. If your portfolio of large-cap stocks is up 8% in a given year, is that performance good or bad? The percentage gain by itself doesn’t tell you much. But if your stocks rose 8% and the S&P index that year was up only 6%, then your portfolio had A+ performance. On the other hand, if your stocks rose 8% and the S&P index was up 10%, then you might want to readjust your stock holdings to better capture market growth.

Make sure that your financial advisor tells you the performance of the S&P index when he reports the performance of your large-cap stocks. Knowing that your stocks were up 8% is only part of the picture. You need to know the performance of the benchmark to determine if you are outperforming the market.

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