Benchmark
In investing, as in any other activity, you can't do without evaluating the result. The criteria are stock indexes, the best-known of which are called benchmarks. In addition to evaluation of what was done in the past, they also help investors to make money in the future.
A standard indicator, which can be used to estimate both the general state of the market and the situation in a certain segment, as well as profitability of securities and even the work effectiveness of the investment (portfolio) manager, is called a benchmark. This term is used by exchange traders and investors.
As a rule, stock indexes, prices for the key assets, currency quotations and interest rates serve as benchmarks. Sometimes indicators, which take into account such terms as dividends, market trends, etc., are used in addition to traditionally used benchmarks.
Determining a benchmark is an important aspect of investment activity because it helps to select suitable objects for investment and assess the result later. The analysis of the investment portfolios profitability is done by comparing them to a benchmark indicator. The principle is simple: if the profitability is higher than the benchmark, you are on the right way. If it is lower, you need to think twice.
However, not every indicator has the status of a benchmark. To become a benchmark, it must be understandable and popular among market participants, who would be able to constantly monitor its value.
Who sets the Benchmarks
This is the prerogative of banks (including the Central Bank), stock exchanges and analytical agencies that process and analyze information received from market participants.
These banks, agencies and stock exchanges calculate the benchmarks set by them using various methods, including the use of mathematical formulas. They also regularly evaluate the level of correctness and relevance of the indicator in order to correct the calculation methods, if necessary.
The main US administrators are such structures as, for example, the NASDAQ New York Stock Exchange or the Energy Information Agency (EIG, Energy Intelligence Group), in other countries - London, Paris, Tokyo stock exchanges and others.
Main Benchmarks on the stock market
In the stock market, benchmarks usually are Trading System Index, which includes shares of the country's largest companies, is calculated as follows: the value of each participant's share is multiplied by its share in the list, and the resulting figure is added to the same indicators of other companies. There is a restriction: the share of one participant must not exceed 15%. The TS Index is calculated in U.S. dollars, and it is affected by exchange rate changes.
Among the favorites of stock markets are:
S&P 500. The list includes more than 500 largest American public companies. The index is prepared by Standard & Poor's.
DAX (Germany). It is the most important index of the country, the basket of which includes shares of blue chips of Germany. The index also takes into account dividends paid on securities. It is calculated by the Frankfurt Stock Exchange.
FTSE-100 (United Kingdom). The index basket includes 100 large public companies. It is calculated by FTSE Group, owned by the Financial Times and the London Stock Exchange.
Nikkei 225 (Japan). The index is the average of 225 most liquid stocks. It is calculated by the Tokyo Stock Exchange.
Examples of Benchmark use
Benchmark indicators are used as an analytical tool. Let us imagine an investor who wants to buy an asset that would seriously and permanently provide him with a regular income.
If an investor is competent, first of all he will compare the profitability indicators of the fund he is interested in with one of the benchmark indexes. If the fund and the benchmark for quite a long time go side by side, showing positive dynamics, the asset can be purchased unconditionally.
Benchmarks are also used to identify oversold (cheaper but with upside potential) stocks. When an index is steadily rising, but several stocks in its list are falling, traders usually try to buy such securities and keep them, expecting a price increase (by the way, it is not a fact that it will surely happen).
In addition, benchmarks are actively used in short-term deals (intraday trading). For example, the futures traded at the stock market are nothing but a derivative of the benchmark Trading System Index.
And finally, the comparison of portfolio profitability with a benchmark can be very helpful in evaluating the effectiveness of made investment.
Benchmark error
A benchmark error is selecting the wrong benchmark in a financial model. This error has a significant impact on the data dispersion of an analyst or academic. It is important to choose and apply the most appropriate benchmark in your calculations, when creating a market portfolio under the capital asset pricing model (CAPM). For example, there is a need to have a portfolio of U.S. equities according to the CAPM. In this case, it would be a mistake to use the Japanese Nikkei index as a benchmark. Respectively, if there is a need to compare the profitability of your portfolio, you should use an index containing similar stocks. For example, if the portfolio contains a lot of tech-heavy, it should be the Nasdaq index, not the S&P 500, as the benchmark.
As we can see, the benchmark really helps. One of the investor's tasks is to choose the one that is right for him. And it is better to do it at the moment of portfolio formation.
Investment in a Benchmark
It is possible, but not in the benchmark itself, so in an Exchange Traded Fund - ETF, which exactly (or with minimal deviations) repeats the structure of the chosen benchmark index. Buying a share in such a fund would be, in fact, an investment in a benchmark.
It is also possible to save on commission for the fund and form a portfolio following the benchmark. However, this option requires not only practical experience, but also significant capital.
