Understanding the different index components can be very helpful in making comparisons and in explaining why your portfolio as a whole doesn't match up to one specific index.
Q. I am trying to compare the returns on my portfolio to the average returns of the stock market, but I am confused by the different index returns that are published in the newspaper. Which indices should I be using for comparison purposes?
The Dow Jones Industrial Average focuses on the 30 largest New York Stock Exchange-traded U.S. corporations, which collectively represent almost 20% of the market's total value. As industries and companies change, so can the 30 stocks comprising the index. However, due to its limited holdings of the largest domestic corporations, the index excludes many sectors of the market, and is not an adequate basis of comparison for the overall market.
The Nasdaq (National Association of Securities Dealers Automated Quotation System) index measures the performance of all 3,300 domestic and foreign stocks available through the Nasdaq trading system. A common misconception is that this index is a barometer of smaller stocks. The index is actually weighted on the basis of market values, and it contains companies that are leaders across all areas of business, including technology, retail, communications, financial services, transportation, media, and biotechnology.
The Russell 2000 index is the key barometer and indicator of companies on the smaller end of the capitalization spectrum. This "small cap" index is made up of 2,000 smaller U.S. companies that together represent approximately 10% of the U.S. stock market's total value.
The MSCI "EAFE" (Europe, Austral-asia, and the Far East) index consists of approximately 1,600 foreign stocks listed on the exchanges of 20 developed countries representing all major industry groups. The EAFE Index serves as an appropriate benchmark for mutual funds that invest in these countries. Newer indices are now being developed for specific countries and regions, including emerging markets.
The performance of the bond market is tracked in a variety of ways. The most frequently quoted figure is not a composite average; rather, it is the return on the U.S. government's 30-year Treasury bond. Most newspapers will quote the current yield as well as the change in price or yield from the previous day's close. Investors watch government bond prices not only as a measure of their own bond performance, but also as an indicator of market interest rate changes, since there is a direct correlation between the two.
Both the Salomon Brothers index and the Lehman Brothers index track publicly traded government and corporate bonds. The only way to make a valid performance comparison of your bond portfolio to a specific index is to know the average length of maturity as well as the quality of the bonds within the index.
Index tracking can be very useful in comparing the performance of your individual stocks, bonds, or mutual funds relative to a specific benchmark average. The validity of the comparison, however, depends on your ability to determine which index serves as the appropriate benchmark for your specific holdings.
Note: The indices described above are unmanaged and cannot be invested in directly.