What Are Benchmarks?

April is Financial Literacy Month, and our goal is to help you raise your money IQ. In this series, we'll tackle key economic concepts -- ones that affect your everyday finances and investments -- to help you make smarter choices with every dollar decision you face.

Today's term: benchmarks.

You probably think of a benchmark as simply a baseline for comparison, something you can measure performance or judge quality against -- and if so, you're right. But if you're like many people, you don't apply benchmarking sufficiently in your financial and nonfinancial life, and you may suffer for that.

In Business and Investing

There are many forms of benchmarking, especially in the business world. If you're developing a new electronic device, you'll likely benchmark it against existing similar products, as you aim to meet or exceed their capabilities. Computer-related companies, for example, measure their products' or systems' effectiveness against industry benchmarks or standout performers. In the auto industry, Volkswagen (VLKAY) has developed a new modular car-building methodology, and both Ford (F) and Toyota (TM) are already using it as a benchmark against which to measure themselves.

In the investing arena, benchmarks are also critical. You may have noticed, for example, when reviewing documents related to mutual funds that you own, that the fund companies will report their performance and will compare it to a benchmark. A stock fund, for instance, might show how it has outperformed (or underperformed) the S&P 500. A bond fund might compare its performance to a bond index.

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Many of us might glance at those comparisons and then move on, or perhaps we'll just ignore them completely. That's a mistake.

Consider, for example, that within the world of mutual funds, it's hard to find lower fees than those for some broad-market index funds, such as S&P 500 index funds. The Vanguard 500 Index Fund (VFINX), for example, charges just 0.17 percent annually. In contrast, many stock mutual funds, especially those actively managed by pros instead of those that track relatively stable indexes, charge more than 1 percent, and sometimes much more.

That's not necessarily bad -- if the managed funds are delivering much stronger results. Unfortunately, that's usually not the case. The historical trend is that most managed funds underperform simple index funds.

Thus, index funds serve a critical role as benchmarks: If your investments are not beating their benchmarks, then it may be time to move your money elsewhere -- perhaps into an investment that tracks that benchmark.

Correct Use of Benchmarks

There are some common mistakes people make when using benchmarks to judge the performance of their investments.

One is taking a short-term view. Over a few months or a year or two, a fund might do unusually well or poorly. So you have to look at the big picture and measure performance with an eye on the long-term.

Be sure to use the right benchmark, too. If you're invested in a small-cap mutual fund, for example, and you're comparing its results with the S&P 500, that's an apples-and-oranges proposition, since the S&P 500 is made up of bigger companies that generally can't grow as rapidly as successful small ones.

Check out the average annual returns for the S&P 500 and the small-cap-focused Russell 2000 index:

Data: Morningstar.com, Russell.com.

Also, be sure to review the performance of your whole portfolio regularly, and to compare apples to apples. For example, if your portfolio is 50 percent stocks and 50 percent bonds, you shouldn't be comparing its overall performance to the S&P 500, as that's 100 percent stock-based.

In Your Life

Benchmarks can involve other parts of your life, too. If you're buying a home, for example, you'd do well to compare it with the rest of the neighborhood, to make sure it's not the best or worst house on the block, as those won't always offer the best value.

But trying to live up to the benchmarks of celebrity lives or even our seemingly well-off neighbors can lead you and your finances astray. If you're living beyond your means by trying to keep with the Joneses, and you're accumulating a lot of credit card debt, you're in deep danger. And, don't forget, those folks you're trying to compete with may be hiding financial troubles themselves.

Learning about some simple economic concepts can make you a better financial and nonfinancial thinker and decision maker.

Motley Fool contributor Selena Maranjian owns shares of Ford. The Motley Fool recommends Ford. The Motley Fool owns shares of Ford. Try any of our newsletter services free for 30 days.

More money terms:
Asset allocation
Compound interest
Opportunity cost

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