Choosing The Right Investment Benchmarks
Whether the stock market is going down, or
up, most investors compare the performance of their portfolio and the
individual components of their portfolio against one of the major market
indexes. Typically, the index of choice is the Dow Jones Industrial Average or
the S&P 500. Some investors pick the current hot index, such as the Nasdaq was
in 1998 and 1999. But this use of a single “market” index usually equates to
comparing apples to oranges, say many Certified Financial Planner™
professionals.
Isn’t using a single benchmark against
which to compare your entire portfolio—and the individual components of the
portfolio such as domestic stocks and bonds, mutual funds, real estate
investment trusts, foreign stocks and certificates of deposit—the simplest
method? Simplest, yes, but it tells a false story. Here’s why.
By design, a well-diversified portfolio is
made up of different types of assets that don’t correlate strongly to each
other. Large-cap stocks may boom, as they did in 1995–1999, while U.S.
Treasury bonds didn’t do nearly as well. But in 2000 and 2001, when large caps
slumped, Treasuries did well.
The same goes for different types of
stocks. Small cap didn’t do as well as large cap in 1995–1999, but, like
Treasuries, they outperformed large cap in 2000 and 2001. Mixing these
uncorrelated types of assets in a single portfolio theoretically reduces risk
and, argue some, actually enhances total return over time versus investing in
a single type of asset.
Consequently, there’s little value in
measuring this year’s performance of a bond mutual fund in your portfolio
against the return of the large-cap S&P 500 Index, or comparing the returns of
your foreign stock mutual funds against the Nasdaq. As for comparing the
return of your overall portfolio against a specific benchmark, planners
suggest that you really should compare it against the return benchmark you
established as part of your investment plan. Perhaps you want the portfolio to
return ten percent a year in order to accomplish your financial goals. Then
the portfolio’s return should be compared against that ten percent benchmark,
not what the Dow does for the year. (And remember, the return of your
portfolio will inevitably go above or below your personal benchmark in any
given year; it is whether you are accumulating enough dollars over time that
counts.)
The real value of market indexes is for
comparing how well related investments in your portfolio are doing. For example,
is your large-cap mutual fund performing well against a large-cap index such as
the Dow or the S&P 500? If it’s doing much worse, why?
Here, are some of the benchmarks to keep in
mind and what they measure.
The Dow. The
godfather of stock market indexes and still the most watched by individual
investors. Some critics complain, however, that it is too narrow because it
follows only 30 large-cap stocks.
S&P 500. More
popular among investment experts because it follows a much larger number of
stocks, it too has its critics. One complaint is that because the index is cap
weighted, the returns of a relatively small number of the largest stocks in the
index account for most of the index’s performance. And it still follows only 500
of the roughly 7,000 publicly traded stocks in the United States. Some experts
think the Russell 1000, which follows the 1,000 largest companies, is a better
index.
Nasdaq Composite.
A value-weighted listing of the nearly 5,000 stocks listed on the Nasdaq.
Critics complain that the huge technology stocks that dominate the index skew
the weighted index.
Russell 2000.
This tracks 2,000 smaller company stocks.
Wilshire 5000.
This tracks all publicly traded stocks in the country—around 7,000—though the
largest stocks in the index still dominate the index’s total return.
Lehman Government/Corporate Bond Index.
Made up of government and investment-grade corporate bonds with maturities of
one to ten years. This is what you should compare most of your bonds and bond
funds against, not the S&P 500.
MSCI-EAFE. The
Morgan Stanley Capital International-Europe, Australia Far East Index follows
around 1,000 of the largest stocks in Europe and Pacific Basin markets.
Solomon Brothers World Bond Index.
This tracks fixed-income investments, mostly in Europe.
In addition, there are numerous other
specialized indexes such as value, growth and mid-cap stocks, and municipal
bonds.
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