An investment benchmark is an instrument used by investors to measure how an investment performed in relation to the broad stock market. Selecting the correct benchmark will give you a comparable gauge to measure your portfolio performance. Unfortunately, there appears to be an endless amount of benchmarks to choose from and selecting the right one is not always easy to do. To add to the confusion, often a fund may track more than one sector or asset class.
Some of the most noteworthy indexes or benchmarks are the Dow Jones Industrial (DJIA), Standard & Poor's Composite 500 (S&P 500), and the NASDAQ composite. Understanding these three major indices can help you gauge the "temperature" of the US markets on any given day. Trying not to jump off a cliff after you look at the dismal 2008 year-to-date performance of these benchmarks is truly the next feat.
Dow Jones Industrial Average (DJIA)
The DJIA is the most popular index and is quoted nightly on news broadcasts all around the world. The Dow Jones Industrial Average is the oldest US market index which has been around for over 100 years. This index tracks only 30 large blue chip stocks of some of America's largest companies. The value of the Dow 30 Index is price-weighted, meaning that to find the value of the DJIA, one merely has to add up the price of all 30 member stocks and divide by a set denominator. There is a general formula to calculate the denominator which takes into consideration stock splits, spin offs, and dividends.
The DJIA would be a suitable benchmark for a fund whose investment objective was to provide medium to long-term returns of U.S. blue-chip equity growth stocks in a diversified portfolio. The DJIA would not be a good benchmark for comparison if your holdings include small cap stocks or any international companies.
Standard & Poor's Composite 500 (S&P 500)
The S& P 500 is probably the most common benchmark used by investment professionals to measure the performance of their portfolios. It includes 500 of the most widely traded stocks and leans towards larger growth companies. As of July 2008, the companies listed on the S&P 500 are mostly US based companies with only thirteen non-US companies. The S&P 500 represents approximately 70% of the value of the U.S. equity markets and includes companies in six different industries.
Even though the S&P covers most of the market with a base of 500 companies, in practice 45 companies make up more than 50% of the index's value. That's because the index uses a "weighted average market capitalization" when determining the effect each company has on the index. Once the market capitalization has been computed for all 500 companies, they are then added together to get a total for the S&P 500. Then each company is assigned a percentage of the total, which reflects their weight on the index. The larger the percentage of market weight, the more impact the company has on the S&P.
NASDAQ Composite
The NASDAQ Composite Index is made up of over four thousand common stocks and securities. Like the Standard & Poor's 500 the NASDAQ is a value weighted index. Value weighted indices are calculated based on each individual stock's market capitalization. The NASDAQ has a heavy weighting of technology companies and internet stocks. As such, the companies listed in the Composite are considered to have high growth potential. These companies lend well for the individual who has an appetite for more speculative investments. That was proven during the dot.com era where the NASDAQ became the most volatile index ever recorded.
Conclusion
The Dow Jones Industrial Average, S&P 500, and NASDAQ Composite all give an indication of the "temperature" of the stock market. As of the close of the market on June, 30th 2008 all three major indices were down over 12% year to date. As a general rule, these three indices move in the same direction. Once in a while the NASDAQ Composite is out of step with the DJIA and the S&P 500. This was quite apparent in 1999 and 2000. The reason was that technology stocks were red hot and were moving in a different direction than the rest of the stock market.
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