Benchmarking Against an Index

You cannot know if you are winning unless you know what you are competing against. Choosing the right benchmark is the first step.

Key takeaways

• A benchmark is a named index (S&P 500, MSCI World, Bloomberg Aggregate Bond) that matches your allocation and philosophy.
• You must choose your benchmark before you start investing, not after you see how your portfolio performed.
• The most common mistake is moving the goalposts: "Last year I was beating the S&P 500, but this year I will compare to the Nasdaq instead."
• A good benchmark takes 5 minutes to choose and then you stick with it for 20 years.
• If you beat your benchmark after costs and taxes, you have outperformed; if you underperform, you have underperformed—there is no middle ground.

What a benchmark is

A benchmark is a named index that serves as a reference point for performance. Examples:

• S&P 500 (large-cap US stocks)
• Total US stock market (represented by VTI, but the index is the Wilshire 5000)
• MSCI World ex-US (developed and emerging markets outside the US)
• Bloomberg Aggregate Bond (US investment-grade bonds)
• 60/40 (60% stocks, 40% bonds—a blended benchmark)

A good benchmark has these properties:

1. It is investable. You can actually buy an index fund or ETF that tracks it (or very close to it).
2. It matches your philosophy. If you believe in passive indexing, your benchmark should be an index, not the returns of a hedge fund.
3. It matches your allocation. If you are 70% stocks and 30% bonds, your benchmark should be 70% stocks and 30% bonds, not 100% stocks.
4. It is time-invariant. You do not change it based on recent performance or market conditions.

Choosing your benchmark

Your benchmark depends on your investment strategy. A few common choices:

All-in US stocks. If you own only VTI (Vanguard Total Stock Market ETF), your benchmark is the Wilshire 5000 or Russell 3000. Most investors just call it "the S&P 500" for simplicity, though technically the S&P 500 is only the 500 largest US companies.

US + international. If you own 70% VTI and 30% VXUS (international), your benchmark is 70% Wilshire 5000 and 30% MSCI ACWI ex-US (All Country World Index excluding US). Many investors call this the "global stock market."

Stocks + bonds. If you own 60% VTI, 20% VXUS, and 20% BND (bonds), your benchmark is 60% US stocks, 20% international stocks, 20% bonds. You would calculate this benchmark's annual return as the weighted average of the three component returns.

Three-fund portfolio. If you follow the Bogleheads three-fund philosophy (US stocks, international stocks, bonds), your benchmark is whatever allocation you chose. The Boglehead community typically uses 33%–33%–33% or 40%–40%–20%, so their benchmark is the weighted average of those three indices.

The key is that your benchmark should match your intended allocation, not your current allocation. If you intend to be 70% stocks and 30% bonds but have drifted to 75% stocks, your benchmark is still 70/30. The drift is a tracking problem you will identify at your next rebalance.

The moving-goalposts trap

The most common mistake is to change your benchmark after seeing how your portfolio performed. Here is how it happens:

• Year 1: Your portfolio returns 5%, the S&P 500 returns 8%. You underperformed.
• You think: "The S&P 500 is too narrow. Let me compare to the Total Stock Market instead."
• The Total Stock Market returned 4.8%. Now you beat it, and you declare victory.

This is fraud. Not intentional fraud—it is the self-deception that is endemic among investors. You have changed the benchmark to make yourself look better. This destroys the value of benchmarking.

The solution is to choose your benchmark at the start and commit to it. Write it down. Tell your spouse. Put it in your investment policy statement. Commit to comparing yourself to that benchmark for the next 10 or 20 years, regardless of how the comparison looks.

Constructing your benchmark

If your allocation is custom (e.g., 45% US stocks, 25% international, 20% bonds, 10% real estate), you need to construct a blended benchmark.

Example:

• Your allocation: 45% VTI, 25% VXUS, 20% BND, 10% VNQ (real estate).
• Benchmarks: 45% Wilshire 5000, 25% MSCI ACWI ex-US, 20% Bloomberg Aggregate Bond, 10% MSCI US REIT.

Each year, you calculate the return of each component index, then compute the weighted average:

Benchmark return = (0.45 × US Stock return) + (0.25 × Int'l Stock return) + (0.20 × Bond return) + (0.10 × RE return)

You can look up the annual returns of each component index from Morningstar, Vanguard, or the index publisher's website.

For example, in 2022:

• Wilshire 5000 returned -18.1%
• MSCI ACWI ex-US returned -20.5%
• Bloomberg Aggregate Bond returned -13.0%
• MSCI US REIT returned -28.1%

Your benchmark return would be:

• (0.45 × -18.1%) + (0.25 × -20.5%) + (0.20 × -13.0%) + (0.10 × -28.1%) = -8.1% - 5.1% - 2.6% - 2.8% = -18.6%

(This is hypothetical; the actual indices returned slightly different amounts.)

Calculating outperformance

Once you have your benchmark return, compare it to your portfolio return.

Your return minus the benchmark return equals your outperformance:

Outperformance = Your return - Benchmark return

Example:

• Your portfolio returned -17% in 2022.
• Your benchmark returned -18.6%.
• Outperformance: -17% - (-18.6%) = +1.6%.

You beat your benchmark by 1.6 percentage points. This is good, and it tells you that your stock-picking or fund selection was better than average (or you were fortunate with timing).

But wait: did you beat it after costs and taxes? In taxable accounts, you should also account for taxes. If you harvested losses or had dividend income, your after-tax return was lower than your pre-tax return. Compare your after-tax return to the pre-tax benchmark return, not the other way around. (The benchmark never pays taxes—it is a hypothetical investor.)

Long-term benchmarking

Over 10 or 20 years, outperformance is rare. Academic studies show that:

• 80–90% of active managers underperform their benchmark after costs and taxes.
• Among passive index investors, almost all match their benchmark closely (within 0.1–0.5% per year, accounted for by fees).

This is not because active managers are bad or passive investors are better—it is simply that it is hard to beat the market. The market includes all available information, and trying to outsmart it requires knowledge that most investors do not have.

For this reason, many investors expect to match their benchmark, not beat it. If you beat your benchmark by 0.5% per year over 10 years, you have done very well—likely through luck, good timing, or low fees.

Benchmarking real estate and alternatives

If your portfolio includes real estate, private equity, or other alternatives, benchmarking becomes harder. These assets have less liquid markets, and their returns are harder to measure and compare.

A real estate investor might benchmark a rental property against local housing price appreciation plus rental yield. A private equity investor might benchmark against a database of private equity returns (e.g., Cambridge Associates).

For simplicity, many investors just exclude illiquid assets from their benchmarking calculation and benchmark only the liquid portion (stocks and bonds). This avoids the complexity and accepts that they cannot easily compare their alternatives to a market index.

Reporting your performance

When you report your performance to yourself or others, always include the benchmark:

• "My portfolio returned 6.2% last year. My benchmark (60% VTI, 40% BND) returned 5.8%. I outperformed by 0.4%."

Or, if you underperformed:

• "My portfolio returned 4.1% last year. My benchmark returned 5.3%. I underperformed by 1.2%, primarily because I held too much cash and missed the January rally."

This contextualized statement is much more meaningful than just reporting your raw return. It tells you whether your strategy is working or whether you need to adjust.

The emotional payoff

Benchmarking removes emotion from investing. Without a benchmark, you are always wondering, "Am I doing well?" With a benchmark, you know: either you beat it, matched it, or underperformed it. The numbers are objective.

This is powerful. Over a 20-year period, you will have years of underperformance and years of outperformance. Benchmarking prevents you from taking credit for lucky wins or blaming yourself for unlucky losses. It keeps you focused on the strategy and the long term.

Decision flow

Next

You now know how to measure your performance against a fair standard. But raw performance is not the full story; your actual gain depends on taxes and fees. The next article covers after-tax and after-cost returns—the only number that actually matters for your wealth.

Related concepts

• Time-Weighted vs Money-Weighted Returns
• After-Tax After-Cost Returns