Market indexes have long been used by investors to gauge the state of the market. By comparing the current total value of a set of investment assets (stocks or bonds) against their base value on a specific date, indexes allow investors to measure the performance of assets hourly, daily, weekly, monthly, and yearly. They are also used to track market performance over long periods of time.
As a pricing mechanism, market indexes are meant to act as a representative snapshot of the entire market or market segment—then a mirror for investors' own asset holdings. This is where many investors go wrong. Each index represents a particular type of asset and specific set of characteristics. If the criterion of the portfolio that is being evaluated differs from these, the comparison becomes akin to measuring apples against oranges.
The Usual Suspects
Today, there are thousands of stock indexes and they can cover literally anything, from individual countries and sectors (like the Hong Kong's Hang Seng Index and the NASDAQ 100 Technology Sector) to resources and commodities (such as the NYSE ARCA Oil & Gas Index).
The most common indexes in the United States are the Dow Jones Industrial Average (DJIA) and the Standard & Poor's 500 (S&P 500). The oldest index, the Dow Jones, established in 1896, averages 30 key stocks traded on the New York Stock Exchange and the Nasdaq. The S&P 500 is an index of 500 large cap stocks and has been around since 1957 (though its earlier incarnations, the S&P 90 and the S&P 233, provide information dating to 1926). While newer than the Dow Jones, its larger sample size has made the S&P 500 the more popular benchmark for the U.S. stock market. They both have similar return sets almost every year. One of the major differences and major issues is the S&P misses a key, volatile chunk of information from 1896-1926.
An Error of Comparison
One common mistake investors make is comparing an entire portfolio of stocks, bonds, and cash to the S&P 500, which is comprised of only stocks. Stocks typically go up more than bonds or cash, so compared to the S&P 500 the portfolio will almost always underperform. Investors then become frustrated, without realizing that it’s the cash and bonds that are dragging down their portfolio’s performance.
It’s fine to compare to a single index where appropriate, but sometimes a blend of indexes is needed in order to represent properly each piece of an investor’s financial pie. For example, if 60 percent of an investor’s portfolio is stocks and 40 percent of those are large caps, then that 40 percent can be compared to the S&P 500. The rest should be compared to other indexes that specifically represent those portions of the portfolio.
Accounting for Fees
Investors also often fail to realize that it’s not possible to invest directly in an index. Investments have fees that indexes do not. In order to make a proper performance comparison to an index, investors should take 2 percent off of the index return in order to adjust for the management fees that will be deducted from the investor’s portfolio returns.
At the end of the day, investors compare their portfolios against indexes in order to understand how their portfolio is performing. By accounting for the fees and expenses that might affect the results of that comparison, and by utilizing a blend of indexes that reflect the portfolio’s unique characteristics, investors can get a more accurate picture of how their portfolio measures against the market.
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