What Is Benchmark Error?
Benchmark error is a situation in which the wrong benchmark is selected in a financial model, causing the model to produce inaccurate results.
This type of error can be easily avoided by selecting the most appropriate benchmark possible when configuring the model. Although benchmark error is sometimes confused with tracking error, the two terms have distinct meanings.
Key Takeaways
- Benchmark error is a situation in which the wrong benchmark is selected in a financial model, causing the model to produce inaccurate results.
- Investors and managers alike try to minimize benchmark error in order to ensure that they have an accurate understanding of their relative investment performance.
- An appropriate benchmark is one that matches the region, industry, volatility, market capitalization, and liquidity of the securities in a portfolio, along with other factors.
Understanding Benchmark Error
A benchmark, also called an index or proxy, is a standard against which the performance of a security, investment strategy, or investment manager can be measured. It is therefore important to select a benchmark that has a similar risk-return profile of the security, strategy, or manager in question. Otherwise, the analysis could produce conclusions that are misleading and unreliable.
Today, investors have thousands of benchmarks to choose from. These include not only traditional equity and fixed income benchmarks, but also more exotic benchmarks created for hedge funds, derivatives, real estate, and other types of investments.
The choice of an appropriate benchmark is important to investors and investment managers alike. Investors and managers keep a close eye on their investment portfolios and their benchmarks to see if their portfolio is performing in line with their expectations. If the portfolio’s performance deviates significantly from the benchmark chosen, it may indicate that style drift has occurred. In other words, it might indicate that the portfolio has drifted away from its desired risk tolerance and investment style.
Examples of factors considered when selecting an appropriate benchmark include the region, industry, volatility, market capitalization, and liquidity of the securities in question.
Real World Example of Benchmark Error
Alison is constructing a portfolio of American technology stocks using the Capital Asset Pricing Model (CAPM). When considering what benchmark to use, she rejects using the Japanese Nikkei index as her benchmark because she determines that it is an inappropriate comparison for American stocks and would therefore introduce benchmark error.
Instead of the Nikkei index, Alison decides to use the Nasdaq index as her benchmark, which represents prominent American technology companies that are similar to the companies she intends to include in her portfolio.
FAQs
Benchmark error is a situation in which the wrong benchmark is selected in a financial model, causing the model to produce inaccurate results. Investors and managers alike try to minimize benchmark error in order to ensure that they have an accurate understanding of their relative investment performance.
What is benchmarking in simple terms? ›
Benchmarking is a process of measuring the performance of a company's products, services, or processes against those of another business considered to be the best in the industry, aka “best in class.” The point of benchmarking is to identify internal opportunities for improvement.
How do you interpret a benchmark? ›
A benchmark is simply a test that helps you compare similar products. Each of our benchmarks produces a score. The higher the score, the better the performance. So instead of trying to compare devices by looking at their specifications, you can just compare the benchmark scores.
What are the examples of benchmarking? ›
What are benchmarking examples?
- Call centres. Call centres often use benchmarks to understand their customers' satisfaction levels. ...
- E-commerce. ...
- Hospitality. ...
- Health care. ...
- Peer benchmarking. ...
- SWOT analysis. ...
- Performance benchmarking. ...
- Process benchmarking.
Students are given remediation in their reports based on their incorrect answers.
How do you calculate benchmark error? ›
The simple way to calculate tracking error is to take the fund's performance and subtract the benchmark index performance. If a benchmark index generated a 15% return last year and a fund that tracks that index generated a 13.7% return, the tracking error would be -1.3% (13.7% - 15%).
Which is the best example of benchmarking? ›
Functional benchmarking
For example, you can compare your customer service process with that of a hotel chain, or your logistics process with that of a courier company. This can help you discover new ideas and best practices that you can adapt and apply to your own processes, and gain a competitive edge.
Is benchmarking a good thing? ›
Benchmarking is the process of comparing your business's performance to that of others in your industry. This can help you identify areas where you shine and need improvement. Benchmarking has many benefits, including improving productivity, increasing efficiency, and gaining a competitive edge.
What is the main purpose of benchmarking? ›
The goal of benchmarking is to create new methods or improve current processes to meet that higher standard. It's not a one-time effort. Rather, it's another part of continuous process improvement that the best organizations commit to if they want to stay competitive.
What are the three types of benchmark? ›
There are many different types of benchmarking that fall into three primary categories: internal, competitive, and strategic.
- Internal benchmarking. ...
- Competitive benchmarking. ...
- Strategic benchmarking. ...
- Select a subject to benchmark. ...
- Decide which organizations or companies you want to benchmark. ...
- Document your current processes.
A benchmark is simply a test that is used to compare similar products. A computer benchmarking program works by running a series of well-defined tests on the PC to measure its performance. Benchmarks developed by UL Solutions produce a score that you can use to compare PC systems.
Why is it called benchmark? ›
The word benchmark has its origins among surveyors who chiselled these marks in stone to indicate levels and heights as reference points from which the constructions could be calculated. An angle-iron was placed within the cuts to form a “bench” on which to place a levelling rod.
What are the most common benchmarks? ›
Some widely used benchmarks in the stock market are the Wilson 5000, Dow Jones Industrial Average, and the Russel 2000.
What are benchmarks in workplace? ›
Benchmarking involves comparing your performance against the performance of competitors. Key performance indicators (KPIs), on the other hand, are quantifiable measurements that help you track performance against specific business goals. You can use benchmarking to help you set your own KPIs.
What are the four types of benchmarking? ›
There are four main types of benchmarking: internal, external, performance, and practice. 1.
What does benchmark mean in cyber security? ›
What are security benchmarks? Security benchmarks are a measure of an organization's baseline of security performance, the improvements to its security programs over time, and comparisons of its performance against industry peers, competitors, and different business units.
What does benchmark mean in college? ›
Therefore, the Benchmarks represent a criterion for success for a typical student at a typical college. As such, they give students, parents, and counselors useful guidelines to assess whether a student has mastered the necessary skills to have a reasonable chance of success in college.
What does benchmark mean in grading? ›
In education, benchmarking occurs when measurable standards for achievement are set for each grade level. Benchmarking may consist of ranking schools based on achievement, comparing achievement standards between students, and establishing best practices for learning and teaching.
