April 23, 2013


Credit: audfriday13
You know all those acronyms you see scrolling across buildings in Times Square? What about those acronyms that just keep coming across the bottom line of your television on those financial channels like some sort of endless “follow the ball” sing-a-long? What are those things? Many people know that when the arrows are pointed up, the font is green, and the person ringing the bell at the end of the day is smiling that those acronyms have done well, and when the arrows are pointed down, the font is red, and the person ringing the bell at the end of the day is frowning that those acronyms haven’t done so hot. But really, what are those things? Let’s talk about some of those acronyms, what makes them different, and how I would propose you think about indices (the fancy plural of index) relative to your own investment accounts.

  • DJIA - The Dow Jones Industrial Average (DJIA) is a popular U.S. market index that was created in 1896 by The Wall Street Journal editor, Charles Dow, and named after statistician, Edward Jones. The index is designed to gauge how 30 large, publicly owned companies based in the United States have fared during a trading session. The companies are primarily made up of industrial and consumer goods manufacturers, and the editors of The Wall Street Journal (who choose the companies that make up the DJIA) have historically chosen companies that have been around for a while, have a proven reputation, and will likely be around for a lot longer. Despite being made up of only 30 stocks, the DJIA is widely considered to be a useful market indicator in the U.S.
  • NASDAQ - The National Association of Securities Dealers Automated Quotation (NASDAQ) was created in 1971 and was the world’s first electronic stock market. The NASDAQ is a computerized system that allows investors to trade more than 5,000 stocks, many of which are technology companies. While the DJIA is simply an index, the NASDAQ is an actual exchange like the New York Stock Exchange (NYSE) where buyers and sellers can trade securities. Although not always the case anymore, most NASDAQ stocks have ticker symbols (abbreviations representing a company) of four letters or more whereas most NYSE stocks have ticker symbols of three letters or fewer.
  • S&P 500 - The Standard and Poor 500 (S&P 500) is a popular U.S. market index based on 500 large cap (large market capitalization) U.S. companies. A committee of analysts and economists selects the companies that become components of the S&P 500 based on size, liquidity, earnings, stock price, and industry. The S&P 500 was first published in 1957 and, because it includes more companies than the DJIA and is less skewed towards technology than the NASDAQ, many people regard the S&P 500 as the best representation of the overall U.S. market and U.S. economy.
  • MSCI EAFE – The Morgan Stanley Capital International Europe, Australasia, and Far East (MSCI EAFE) is an international index that attempts to represent large and mid-cap companies across the developed world, excluding the United States and Canada. The index was created in 1969 by Morgan Stanley and is made up of more than 1,000 stocks in more than 20 countries. The MSCI EAFE is probably the most famous international market index in the world.
While I could go on and on about many of the other relevant and useful stock indices out there, I would like to also share with you a few thoughts on how I wish I could convince my friends, family members, and clients to view stock indices. You see, one of the many hats I wear as a financial planner is that of an investment advisor, meaning that many of the clients I serve have questions for me relative to their investment performance versus the performance of the indices they constantly hear about by newspaper, television, radio, and smartphone. It’s perfectly natural for someone to want to analyze their investment performance relative to a benchmark of some type, but it’s important to also realize an index is just an index. If you have a lot of cash or bonds in your portfolio and the DJIA has a huge rally, your overall return will probably lag the index because you’re not solely invested in 30 stocks. If the technology sector has a dot-com bubble burst and the rest of the market remains fairly flat, your diversified portfolio investment performance will probably outperform the NASDAQ because you are more diversified. If you’re all in on Greek shipping stocks, your performance probably won’t match the returns of the S&P 500 because it’s not even comparing companies based in the same country!
Your investment return versus the returns of indices is not apples to apples; it’s apples to oranges. If your investment return is substantially and repeatedly different than the direction of appropriately comparable indices, you may need a new investment strategy or maybe even a new investment advisor. If your investment return versus the returns of appropriately comparable indices are in the same direction, reasonably close, and you can understand how your allocation or risk tolerance is different than that of the index you are comparing your return to, then normally, I wouldn’t be too worried. Someone gloating over how their international small cap stocks outperformed the DJIA’s 30 U.S. large cap stocks makes no more sense to me than someone bemoaning that their conservatively balanced portfolio made up of cash, bonds, and diversified stocks underperformed the all-stocks S&P 500.
Indices are good points of reference and can be decent benchmarks, but so are exit signs on the interstate. I hope the next time you see something that resembles DJIANASDAQS&P500MSCIEAFE-like gibberish you will remember a few things from this post about what a few, common indices represent, and will think of them as relative - not absolute - performance benchmarks to your own investment portfolio.

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