Recently I was on vacation with a friend, and while enjoying the sunshine she received a CNN alert…
Breaking News: Dow Jones Industrial Average soars to an all time high.
She then asked me what the Dow Jones was exactly … “Should I know what this means?” My response was, “it’s a stock market index, of course.” Seeing the perplexed look on her face, I realized that she had no idea what I was talking about. After having this conversation, I wanted to share with you what I shared with my friend.
- What is a market index? – A stock market index is simply a measurement of the value of the market or a section of the market. Let’s break it down into a simple example. Assume ABC index is made up of 6 companies. At the end of trading on Monday the index is at 5,000 points. On Tuesday, three of the companies go up in value, two of the companies go down and the sixth company stays the same. The total value of the stocks change by 3% on Tuesday, so now the index is at 5,150 points. This tells you that this section of the market went up in value from Monday to Tuesday.
- Why are market indexes important? Choosing appropriate investments is only the beginning. One of the biggest challenges of an investor is to determine how well your portfolio is performing. Are you lagging behind the market or beating it? You can only know the answer to these questions if you have something to compare your investments to. Indexes allow you to measure the performances of your investments against an appropriate benchmark.
- How do you choose the right benchmark? In general, when you are tracking the performance of an investment, you look at a benchmark that is most similar to your investment. For example: If your portfolio is all U.S. large cap stocks you would likely use the S&P 500 as your benchmark. If your portfolio is all fixed income then you would most likely benchmark against the Barclays Aggregate Bond index. If your portfolio is a combination of both large-cap stock and fixed income you would want to use a blended benchmark of the two indexes.
- All of this is for naught if you don’t know what indexes track which stocks. Here are some of the most common market indexes and the companies they are comprised of.
- Dow Jones Industrial Average (DJIA) – This is one of the most popular measures of the market. A.K.A. “The Dow” or “Dow 30” is a price-weighted measure of 30 US blue-chip companies. The index covers all industries with the exception of transportation and utilities, which are covered by other Dow Jones indexes.
- S&P 500 Index - This index is based on 500 U.S. large cap companies that have common stock listed on the NYSE or NASDAQ. These companies are representative of the industries in the U.S. economy.
- Russell 2000 – This index tracks 2,000 small-company stocks. It serves as benchmark for the small-cap component of the overall market.
- Dow Jones Wilshire 5000 – This index covers over 5,000 US companies listed on major stock exchanges. This includes US companies of all sizes across all industries.
- Barclays Capital Aggregate Bond Index – This is a broad-based benchmark that measures the investment grade, US dollar-denominated fixed-rate taxable bond market.
- MSCI EAFE Index – This index is designed to measure the equity market performance of developed markets outside of the U.S. and Canada. EAFE is an acronym that stands for Europe, Australasia and Far East. (Check out Sarah DerGarabedian’s blog post from last week to read why it’s important to have an international allocation – http://wp.me/plOKq-oE)
- It’s important to remember when comparing your investment returns to compare your results to the long-term market, not just the past year. Typically analysts look at 3, 5 and 10 year returns. Short-term results can often be misleading due to short-term volatility. A quick Google search should provide you with the long-term returns of any of the major indexes.
After explaining all of this information to my friend, I think she had a better grasp on market indexes and hopefully this information is helpful to you too. One realization that came from our conversation is that sometimes financial advisors (nerds) forget that things that seem so common to us aren’t as familiar to those not in the industry. We never want a client to leave a meeting or conversation feeling confused or uncertain. If you have questions, please ask! We may just write a blog post about it.
Ashley Woodring, CFP®