When you want to gauge performance, it's necessary to have something to compare against. Race cars have lap times, microprocessors use clock speeds and investments use benchmarks. For serious investors, benchmarking is essential. But how can you pick an appropriate benchmark for your portfolio? Here's a primer to help you get started.

What Is a Benchmark?

A benchmark is a tool for measuring the performance of an individual investment or portfolio of investments. According to Andrew Clark, Lipper's head of research for the Americas, a benchmark "is like a ruler." Clark says, "A ruler tells you how tall you are; a benchmark -- in terms of investing -- tells you how much money you've made."

Benchmarks are essentially a way to put your portfolio in perspective by comparing it against the market as a whole. For example, while a year-end 6% positive return might not be your idea of a great year, if your particular benchmark is up only 1% for the year, then you did pretty well.

Typically, indices like the S&P 500 ( SPX) and the Dow ( DJIA) are used as benchmarks because they're readily available to investors and provide a good idea of how the market is doing (see "Index Funds: Define Your Stock Market Index" ).

However, benchmarks aren't relegated to indices -- comparing an investment vehicle like a mutual fund against similar (or "peer") funds is also a valuable way to get a feel for performance.

Pick a Meaningful Benchmark

Just because the S&P and Dow are popular benchmarks doesn't mean that either is the right one for your portfolio, says Judith Ward, a CFP (certified financial planner) at T. Rowe Price. Ward explains: "Probably the most common benchmark that people use is the S&P 500 index and that is a good benchmark to gauge the stock market. But I think what investors need to understand is the kind of investments that they're in -- whether it's individual stocks or mutual funds -- they need to understand the investment and how it's similar or different from any particular benchmark."

So while the S&P might make a good benchmark for someone invested in large-cap stocks , it might not be a good choice for someone who's invested primarily in emerging markets . Even if your money is in U.S.-based companies or foreign companies (via ADRs ), company size is a big factor. For example, someone invested in small-caps might find the Russell 2000 Index ( RUT) to be a better benchmark than the S&P 500 or the Dow (see "Define Your Stock Market Index" ). As Clark puts it, "good benchmarks are fair representations of investments people either can, or allow themselves to purchase."

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