In our last article, we discussed the real rate of return and how that calculation can be used to evaluate the performance of individual assets relative to each other, over the same period of time. In this article, we will explain the value of checking these returns against a benchmark – or a numerical standard that you can use to measure your investment and put its performance more into context.
Different benchmark numbers can be used to make different assessments of your assets. For example, you can use benchmarks to compare the stock’s returns based on the inflation rate or based on assets with other risk levels. Finally, you can even set your own benchmark rates to assure that you are reaching your own particular savings or investment goals. Clearly, this method of asset assessment is extremely versatile and can be very useful for investors with a variety of investment styles.
First, the Consumer Price Index is a measure of the changing prices in a “market basket” of “typical” consumer goods and services purchased by households. While it can be useful for determining purchasing power, it can also be leveraged as a benchmark for determining whether or not your assets are outperforming inflation over time. Basically, the Consumer Price Index (CPI) can be used to estimate inflation. This number can be used in calculating a stock’s real return, as described in our last article, “Assessing the Performance of Your Investments: Real Return.” So, when using CPI to make an assessment of a stock’s performance, you can compare the stock’s real rate of return to zero. This is because your benchmark (the inflation rate or CPI) has been factored into the real rate of return, meaning that the real rate of return basically tells you whether or not you have made a return after inflation. Effectively, if your real rate of return is higher than zero, you’ve made a real gain after inflation. If it is less than zero, you have not beaten your benchmark and the value of your investment has fallen in real terms. For many investors, beating inflation can be a primary goal because they want to ensure that that they are making real, tangible gains over time.
Another benchmark that many investors like to use is called the risk-free benchmark, which shows how much an investor could earn on an investment with no risk. You can find the risk-free rate of return online for many different periods of time. With regard to assessing your assets, you want to compare this risk-free rate to the rate of return your assets have made over the same period of time. The rule of thumb is: if you are taking more risk than the risk-free assets (basically, if you are investing in anything other than bonds), you should expect to see a higher return than the risk-free rate. Further, the greater risk you’re taking, the more your return should exceed the risk-free rate. Investors can use this benchmark to determine whether or not to restructure their portfolios – especially if they have risky investments that are performing worse than expected.
Finally, many investors might set their own personal benchmarks depending on their long-term investing goals. For example, if I invested $500 today and I needed $750 in two years, I would set a yearly benchmark that would allow me to get to that goal using co