FPA Financial Planning Perspectives
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.
April 2002— This column is produced by the Financial
Planning Association, the membership organization for the financial planning
community, and is provided by Rich Chambers, CFP™, a local member in good
standing of the FPA.
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