Start by determining your personal benchmark. In fitness terms, that might mean getting strong enough to carry your 3-year-old around town without getting winded, or it might mean building up enough endurance to climb a mountain. In investment terms, it means setting a benchmark for the returns required to reach your investment goal, whether it is a long-term goal (retirement) or a short-term goal (buying a new house in two years).
Say you want to retire in 30 years. You may know how much money you have to invest today, you can anticipate how much you'll be able to invest in the future, and you have a rough idea how much you'll need in retirement. After crunching the numbers, let's say you find that you need an 6% return per year to meet your goal. That's your personal benchmark.
By knowing that benchmark, you can immediately rule out funds that rarely meet that hurdle each year, such as most bond funds. You can also rule out funds that can sometimes return much more than your personal benchmark, because they probably present an added risk. That would include volatile fund types, such as emerging-markets funds or technology sector funds. Why take on all that extra, unnecessary risk?
Indexes as Benchmarks >>