Suppose you have invested in an equity fund whose value has increased by 5% over the period of one year. How can you know whether this increase in value (the “performance”) is good or bad, whether you can be satisfied with your fund or not?

You will firstly compare this 5% with the interest you would have earned if you had kept your money in a savings account at your bank. Given the paltry interest rates that are currently paid on bank deposits, the yield of 5% achieved by your investment fund is certainly higher. However, comparing a risk-free investment in a savings account with a definitively riskier investment in an equity fund is like comparing apples and oranges.

Of course, you can also compare the 5% performance of your fund with another fund that invests in a similar portfolio of equities. But this will not get you very far either: You’ll know if the performance of your fund is higher or lower than that of the other fund, but you still do not know whether the performance of this other fund was good or bad.