As an investor, it’s perfectly natural to ask, how are my investments doing? Most people look at their account values and if they are up, they are happy and if they are down, they begin to ask questions. But if you really want to know how your investments are doing, you need to consider how your investments are doing compared to what the market is doing, and you do this by looking at market indices.
A market index is a method of tracking the changes of a particular sector of the capital markets. The most well-known indices for tracking “the market” are the Dow Jones Industrial Average and the S&P 500 Index, both of which measure the performance of US large company stocks. However, there are hundreds of other market indices that can be used to track the performance of various parts of the markets. Some indices are very broad, while others measure only a narrow slice of the market.
Here’s an example of how you might use market indices to evaluate performance. Suppose, you own a US large company stock mutual fund that earned 12%, but the S&P 500 returned 15% during that same time period. In that case, the investment underperformed its benchmark index. In other words, the investment actually performed poorly despite its double-digit return. This concept is called relative performance and is a much more meaningful measure of investment performance than just looking at whether or not an investment went up or down.
That being said, there are some limitations to be aware of when using an index to evaluate performance. First of all, if you own a well-diversified investment portfolio, it does not make sense to compare the return of your portfolio to any single index. Instead, you might want to look at a composite index, which is a combination of indices that are grouped together to more closely resemble a diversified portfolio.
Furthermore, market indices do not consider the particular nuances of each investor’s unique circumstances. For example, some investors may need to maintain a higher cash balance to fund expected withdrawals or have portfolios that are allowed to drift away from a target portfolio to minimize taxes or transaction costs. Or, certain portfolios may be tilted toward various risk factors that may not be reflected in the market index. These factors may result in a discrepancy between the portfolio and the index that has nothing to do with investment performance.
So while measuring investment performance using a market index is very useful, what matters more is whether your investments are performing in a manner that has a high likelihood of enabling you to meet your overall goals and objectives. Chances are, if you are broadly diversified, if your portfolio is being managed efficiently and costs are low, you are on the right track.