There's a lot of confusion out there in the investing world, people often say 'the market is down' or 'my portfolio is being out performed by the S&P'... let's clear up what the Stock Market is, what an Index is, and when you should, or should not be worried about what your investment is doing compared to them.
You might hear on financial news stations things like:
Stock Market
A Stock Market is also known as a Stock Exchange. You can trade stocks here, almost all countries have one, and some have several markets.
In the US there are the following markets or exchanges (sourced from Wikipedia):
The Indices
This is a huge issue for financial intelligence. People will often use the incorrect benchmark to measure performance, either intentionally (to sell more product) or unintentionally due to lack of awareness.
Mutual Funds are designed to offer a rate of return that is proportionate to the risk of their investments - start up firms in Greece right now would have to pay a higher premium than the DJIA firms since they are more risky investments.
Index Funds are designed to replicate the indexes, the history of this this means:
If you were to own a Russell 2000 index fund, but watched it drop in value more than the S&P 500, it doesn't necessarily mean that Russell is a 'bad' investment, it just means that the underlying assets within the index move in a different manner to the S&P companies. If you recall, the Russell 2000 is small cap, where the S&P 500 is large cap - so based upon the same economic events, they will move differently.
Typically Small Caps are higher risk investments, so they move in both directions more than the S&P 500 companies would in the face of the same economic event.
Know your benchmarks!
If you are a mutual fund investor (active funds) it is critical that you know your benchmark. Else you could have someone sell you a fund showing how it outperformed the S&P500 for 5 years running, but it really is built up of small cap stocks - which are designed to - but they will also carry more inherent risk. For Index Fund investors the job of benchmarks is easier, as the fund is designed by nature to track a benchmark. This is how unscrupulous salespeople will trick the novice investor.
Conclusion
Next time you are looking at your performance, remember you cannot compare it to the wrong benchmark and get a fair impression. If you want to compare performance of the S&P500 to the Russell 2000 you will have to run a series of calculations to create a risk adjusted return. Lastly, it is important to note that not all investments will match the benchmark perfectly (indeed, an active fund by definition cannot) so there is a concept of best fit to correlation that must be considered.
You might hear on financial news stations things like:
- The S&P 500 is up 50 pts
- The Nasdaq is up 20 pts
- The Dow is down 40 pts
- The Russell 1000 is down 20 pts
Stock Market
A Stock Market is also known as a Stock Exchange. You can trade stocks here, almost all countries have one, and some have several markets.
In the US there are the following markets or exchanges (sourced from Wikipedia):
- BATS Exchange - Kansas City
- BATS Y-Exchange - Kansas City
- C2 Options Exchange - Chicago - Owned and operated by CBOE Holdings
- CBOE Futures Exchange - Chicago - Owned and operated by CBOE Holdings
- Chicago Board Options Exchange (CBOE) - Chicago
- Chicago Mercantile Exchange (CME) - Chicago - Owned and operated by CME Group Inc.
- Chicago Stock Exchange (CHX) - Chicago
- EDGA Exchange - Jersey City - A Direct Edge exchange
- EDGX Exchange - Jersey City - A Direct Edge exchange
- International Securities Exchange (ISE) - New York City
- NASDAQ Stock Market - New York City
- NASDAQ OMX PHLX - Philadelphia -Formerly Philadelphia Stock Exchange (PHLX)
- NASDAQ OMX BX - Boston - Formerly Boston Stock Exchange (BSE)
- National Stock Exchange (NSX) - Jersey City
- New York Stock Exchange (NYSE) - Owned and operated by - IntercontinentalExchange (ICE) - Atlanta Georgia
- NYSE Alternext US - Organized as NYSE Alternext US LLC (formerly American Stock Exchange (AMEX)) - New York City
- NYSE Arca (formerly Pacific Exchange) - Chicago
- One Chicago - Owned jointly by the IB Exchange Group (IB), CBOE, and CME Group - Chicago
The Indices
- The Dow (DJIA) has only 30 companies in it, the number is the weighted average of these large, blue chip firms. It is thought that due to the gravity of these firms, movements in their average are well reflective of the market in general.
- S&P 500 lists the top 500 companies based upon market weighting, it focuses on large cap firms and represents a large amount of the overall market capitalization. There are also: S&P 100, 400,600, 900, 1000 and various growth vs value models.
- The Russell Index
- Russell 3000 lists 3000 stocks, and is intended to closely represent the overall market
- Russell 2000 lists 2000 stocks, the bottom 2000 based on market cap, and as such is considered a small cap index. Similarly the remaining 1000 stocks become the Russell 1000 and represents the large cap segment. There are several other Russell indices, but these are the most common.
This is a huge issue for financial intelligence. People will often use the incorrect benchmark to measure performance, either intentionally (to sell more product) or unintentionally due to lack of awareness.
Mutual Funds are designed to offer a rate of return that is proportionate to the risk of their investments - start up firms in Greece right now would have to pay a higher premium than the DJIA firms since they are more risky investments.
Index Funds are designed to replicate the indexes, the history of this this means:
- first there was the market
- then there was stock trades on the market...
- then came along the reporting companies who said 'this is an index or snapshot of the market'.
- then came firms who bought the companies that were cited by the reporting companies as "the index", so the investment could mimic it.
If you were to own a Russell 2000 index fund, but watched it drop in value more than the S&P 500, it doesn't necessarily mean that Russell is a 'bad' investment, it just means that the underlying assets within the index move in a different manner to the S&P companies. If you recall, the Russell 2000 is small cap, where the S&P 500 is large cap - so based upon the same economic events, they will move differently.
Typically Small Caps are higher risk investments, so they move in both directions more than the S&P 500 companies would in the face of the same economic event.
Know your benchmarks!
If you are a mutual fund investor (active funds) it is critical that you know your benchmark. Else you could have someone sell you a fund showing how it outperformed the S&P500 for 5 years running, but it really is built up of small cap stocks - which are designed to - but they will also carry more inherent risk. For Index Fund investors the job of benchmarks is easier, as the fund is designed by nature to track a benchmark. This is how unscrupulous salespeople will trick the novice investor.
Conclusion
Next time you are looking at your performance, remember you cannot compare it to the wrong benchmark and get a fair impression. If you want to compare performance of the S&P500 to the Russell 2000 you will have to run a series of calculations to create a risk adjusted return. Lastly, it is important to note that not all investments will match the benchmark perfectly (indeed, an active fund by definition cannot) so there is a concept of best fit to correlation that must be considered.
Last edited: