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For evaluating the performance of an investment fund or any strategy we compare it with an appropriate benchmark. For example, if you invest in a mutual fund which is a Large cap fund and the fund was up 7% for the year and you evaluate whether is it a good bet or not? The positive returns are always nice but what if the Indian stock (Nifty 50) was up by 10% for the year, now your investment might not as nice. Benchmarks allow us to evaluate the performance of our investments in a more meaningful way.
Indexes are often used as benchmarks, for example, NIFTY & SENSEX as commonly used as benchmarks for the Indian stock markets. If the index is up by 10% then the performance of your mutual fund or collection of stocks you are holding in a portfolio will be compared with the benchmark 10% number and if your portfolio stocks investments returns are 12% then you beat the benchmark by 2%. Similarly, if your portfolio returns are 7% then you underperform the benchmark in this case.
If the Nifty benchmark index is down by 4% for the year and your portfolio stocks are down by 2% for the year, then it is a loss but then also you outperform the benchmark index.
One of the important aspects of benchmarking is picking the proper benchmarks. For example, you invest in a mutual fund that is HDFC Small Cap Fund which invests in small-cap stocks this means the fund manager is only looking at investing in smaller companies. The appropriate benchmark would not be Nifty 50, but it would be Nifty Small cap 100 index.