A custom index refers to an index tailored as per one’s specific needs and expectations. Although there are many readymade/standard indices available on stock exchanges, they might not always fulfil every individual’s need. To understand the meaning and applicability of custom indices, first we need to understand what we mean by benchmark/benchmarking.
There are always two ways of measuring performance: absolute and relative. Suppose you are participating in a 100m running race. After completing the race you have been told that you took 30 seconds to complete the circuit. This is an example of absolute measurement. However this piece of information does not allow you to understand whether you won the race. Hence it is not a useful way of measuring performance. But if you are told that you finished first, then you understand that your performance was good. Similarly if you are told that your timing was just 2 seconds slower than the race record, this can also be interpreted as good performance. These are examples of relative measurement. In the first case, your performance was measured relative to that of other participants and in second case measurement was relative to previous record.
In finance and investment world, performances are generally measured in relative terms and compared to a benchmark. The benchmark is generally an index, relative to which an an individual stock or basket of stocks performance is measured. Let’s say I define Nifty as my benchmark and invest in a basket of 5 stocks, called “my basket”. Suppose after a month, Nifty has generated a return of 5% whereas my basket has appreciated by 7%, then one can conclude that my basket outperformed Nifty by 2% (7% – 5%).
Let’s consider another example. I now want to invest in a few IT companies and over a period of time compare their performance with that of IT sector in general. Our post on “Sector Indices”, informed us that Nifty IT sector index is a good way of tracking the performance of Indian IT sector. Hence I define Nifty IT sector as my benchmark and invest in a basket of IT stocks that I feel will perform well going forward. After few days, I see that my investment has generated a return of 10%, however my benchmark Nifty IT index has returned 15% during the same period confirming that my IT basket has underperformed the sector index. In other words the stocks that I bought performed poorly when compared to the IT sector in general.
It is prudent to always define a benchmark to measure the performance of your investments. If you are investments are in a specific sector then a sector index might be a good benchmark. However if your investments are sector agnostic, then broader indices like Nifty and Sensex might be good benchmarks.