With a dollar bill, you can usually go out and buy a candy bar or few postage stamps, or even a deeply discounted ribeye steak.
Unfortunately, you may not be able to do so forever, mostly due to the fact that inflation exists.
Inflation is the reason candy bars and postage stamps cost more today than they did five years ago. After all, candy bars once cost just a nickel, and postage used to cost just six cents.
Since inflation is so hurtful, we need to keep a watchful eye on it. If we don’t, it can easily destroy our hard-earned wealth.
What Is a Benchmark?
One easy way we can monitor inflation is by comparing its growth to the growth of our money. This allows us to compare the real value of our money yesterday, today, and tomorrow.
A benchmark is a point of comparison, or a tool we can use to create a frame of reference. This helps us evaluate the performance of our investments.
At Define Financial, we monitor inflation by using an inflation benchmark on all of our investment portfolio performance statements.
How do benchmarks work? Consider a benchmark in your life — maybe even one that you don’t even know is a benchmark. As an example, many people use their high school weight as a benchmark for what their weight should be today. If you weighed 150 pounds in high school, then you shouldn’t weigh any more than 150 pounds today.
Or maybe they’ll do the same with a certain pair of jeans. Once you can no longer squeeze into your jeans from high school, you know it’s time to take a closer look at your diet and calorie intake. Without that pair of jeans, we wouldn’t know we’re starting to get thick around the middle. In this scenario, fitting into old jeans is our benchmark.
Now let’s talk about benchmarks in terms of how they relate to investing. Specifically, what is it like to invest without a benchmark?
Imagine you bought some shares of stock in Facebook, Tesla, Netflix, Google, or anything else fun and interesting. Over time, the price of your stock went up. Maybe you made a few hundred dollars. Maybe you made a few thousand. Either way, you’re pretty excited because you made some money. Good for you!
But, what’s your benchmark? What is your point of comparison? What could you have done in the same amount of time? Was there a better alternative? Did you actually lose money compared to another, better investment?
How can you even answer the question?
When you invest without using a benchmark, you really can’t answer this.
Investing Benchmarks to Keep in Mind
If you’ve ever received an account statement on the performance of your investments, you’ve likely seen an investing benchmark before.
One very common benchmark is the Standard & Poor’s 500 Index. The S&P 500 contains a broad mix of U.S. stocks of large companies. As a result, looking at the S&P 500 can tell you the investment performance of those 500 large U.S. companies.
Of course, there are other benchmarks besides the S&P 500 that track the performance of various markets.
There are benchmarks for stocks of large companies trading in the United States, like the Dow Jones Industrial Average. There are also benchmarks for stocks of companies in international countries, like MSCI EAFE. And there are even benchmarks for junk bonds and separate benchmarks for commodities.
How the Use of Benchmarks Has Changed Over Time
A long time ago, financial planning wasn’t a thing.
The idea that you could plan out your life and optimize your finances to achieve your personal goals didn’t exist. In place of financial advisors, there were professionals known as “money managers” or “investment managers.” These people would take your money and, if they didn’t screw up too badly, turn it into even more money.
Of course, it’s difficult to measure whether an investment manager screws up or not without a point of comparison. Enter the benchmarks.
Stock and bond benchmarks were used to judge the performance of an investment manager. Given that the focus was so narrow, using an investing benchmark (such as the S&P 500) made sense.
The other reason benchmarks were used is more complex. At the time benchmarks were first popularized, investment managers weren’t just trying to grow wealth to keep up with inflation and match the market. They touted their ability to “beat the market” or help you earn a better return than the masses were earning overall.
Of course, over time, it became evident that these investment managers could not beat the market. It was also determined that investment managers didn’t determine investor return as much as the cost of investing did.
As a result, savvy investors have largely moved into low-cost investments today. If you can match the benchmark and keep your investing costs extremely low, you can do well in today’s investing environment.
The Bottom Line: Investing Benchmark
These days, personal finance has become much more sophisticated than investing alone. Instead of looking at just one piece of your life (your investments), financial planners are able to look at everything in your life that involves money. This includes aspects such as:
- Risk management using insurance products
- Estate planning to make sure that your family is set up for success once you’re gone
- Retirement planning to ensure you can stop working at some point
- College planning
- Cash flow and expense tracking
- Debt management
As financial advisors have begun helping their clients manage more than their investments, the way that we look at investments has changed, too.
Investing is no longer only about making the most money possible. Investing has become about having enough money so you can do what you want with your life.
With all of this in mind, it’s smart to use inflation as your point of comparison when you look at your investments. That’s because the S&P 500 (or any other investment benchmark) has little to do with how you are going to be able to achieve retirement, nor can it tell you if you’re on track to accomplish what you want in life.
Your money may be worth less in the future than it is today. However, you can use that knowledge to your advantage.
By keeping track of inflation with respect to your investments, you can make sure you’ll have the cash you need to reach your lifestyle goals in retirement.