When someone mentions the "stock market" most people immediately
think of the S&P 500 or maybe the Dow Jones Industrial average. These
familiar indexes have become synonymous with "the market" even though
combined they only represent approximately 12% of all U.S. stocks. And
that’s not even considering international stocks which make up 60% of
the world’s capital markets.
Indexes made sense fifty years ago because they were easy to
calculate and follow. Although they were only relatively small samples
of stocks, these indexes gave us a general indication of how the market
had performed. Over the last five decades, however, investing has been
revolutionized by the advent of computers and Modern Portfolio Theory.
We now know that proper investing requires six to fifteen different
asset classes. So why do Wall Street and the media continually insist on
referring to only one or two indexes as "the market?"
Let’s look at how the "stock market" performed over a recent 12 month
period (7/1/03 - 6/30/04): the grandfather of all indexes, the Dow Jones
Industrial average, earned slightly more than 12% in the last year. A
common index for small stocks, the Russell 2000, rose over 17% and the
well known EAFE index, which represents international stocks, gained 25%
during the same period.
Did "the market" gain 12% or 17% or 25% last year?
As you can see, a single index simply cannot tell the complete story
of the "stock market." Thinking in terms of a few indexes naturally
encourages investors to make classic investing mistakes. They chase
after the best performing index because they are focusing on the
individual components rather than the comprehensive portfolio. But it’s
the return of the entire portfolio that will determine whether
your financial objectives will be achieved. Investors need a single
benchmark for measuring the return of their portfolio, rather than
piecemeal indexes telling only part of the story.
It’s important to point out that most indexes are not very good at
representing the major asset classes. And asset classes are what Modern
Portfolio Theory tells us we should be investing in. For example, the
Russell 2000 is commonly used to represent the U.S. small cap universe,
but this index actually includes some Real Estate investment trusts (REITs).
There’s nothing wrong with these stocks, it’s just that they shouldn’t
be considered part of the U.S. small cap universe.
Many indexes are also reconstituted each year. Sometimes the changes
are dictated by committee and sometimes by arbitrary measures. These
index changes increase the trading costs without regard for the asset
class the index is trying to model. It has been estimated that the
Russell 2000 index gave up over 2% in return every year from
1993-2004 because of the annual reconstitution. To make matters worse,
this negative effect on the index makes small cap active managers look
better by comparison!
The S&P 500, as another example, is reconstituted every so often by a
committee which tries to select a group of stocks that are
representative of the U.S. economy. We believe this committee approach
borders on active management (timing and picking). We might call it
"active management lite." During the late 90’s the S&P became more and
more dominated by the "new economy" firms, and by 2000 they made up a
significant part of the index. Unfortunately, that was the wrong time to
be adding more "new economy" companies to your portfolio.
Amazingly, Wall Street has yet to create a true benchmark of the
whole market for investors. The industry seems to regularly come up with
new products to sell consumers, but they haven’t devised a simple method
for measuring a portfolio’s performance. We believe it’s time to change
that! The popular indexes really don’t help you measure the success of
your portfolio.
You need some way to measure your portfolio return against the
extended capital market system, which includes small & large U.S.
stocks, as well as small & large international stocks (including
emerging markets). You need a Market Return Portfolio BenchmarkTM.
In the coming months you will more about our
Market Return BenchmarkTM. Soon we will be launching an interactive
MRP Benchmark™ calculator on our website so that investors can
finally have a standardized measure of market return for their entire
portfolio. The Market Return Benchmark™ includes many asset classes which
are combined to represent the capital markets. (The Market Return Benchmark™ includes more than 13,000 equities in contrast to the 30 Dow Jones
Industrial stocks or the 500 stocks in the S&P Index.) This should be
the new standard by which a portfolio is measured – capital market
return.
Investing has become much more of a science than an art. It’s time we
stopped using ancient, ineffective methods of investing (active
management) and outdated tools for measuring success (indexes). It’s
time investors had a benchmark that reflected a market return philosophy
and kept them focused on the complete portfolio, rather than the pieces.
Enter the Market Return BenchmarkTM!
