Picking a stock benchmark that works for you

As published in the Minneapolis Star Tribune 3/20/2021.

Pick a benchmark, any benchmark, for U.S. stocks. Now explain why you chose that one, how it’s built, and why it accurately reflects the market. That suggestion is straightforward enough. The answers? Not nearly as simple.

The vast majority of investors cite the same old indexes out of habit. The Dow Jones industrial average and the S&P 500 have become synonymous with “the stock market.” Where, then, does that leave the Nasdaq or the Russell 2000? Which benchmark is most appropriate for your personal portfolio? And which index are we supposed to focus on (or ignore) when the gap in performance grows especially wide?

That final question has become more important since COVID-19 changed the world and the investment landscape 12 months ago. While it’s understood each index is made up of different components (i.e. companies) and will fluctuate to varying degrees, large baskets of stocks usually ebb and flow together.

That norm, like so many others, no longer seems to apply. In calendar year 2020, the Nasdaq gained 46%, five times that of the Dow (+9%). Year-to-date through March 17, the Russell’s 18% increase has tripled the S&P (+6%).

Volume is one explanation for the discrepancy. The Dow includes just 30 publicly traded companies. The Nasdaq has 100. The S&P 500 and Russell 2000, as their names imply, have significantly more.

Sector concentration matters a lot. Tech companies comprise 21% of the Dow, 27% of the S&P 500 and 48% of the Nasdaq.

Individual weightings also influence index performance. Apple is represented in each of the big three benchmarks, but its 2.5% weighting in the Dow is dwarfed when compared to its 6% slice of the S&P or its 11% slice of the Nasdaq. UnitedHealth Group and Goldman Sachs combined represent 14% of the Dow but only 1.3% of the S&P. They are absent from the Nasdaq.

Not all benchmarks, therefore, are created equal. So, how do you decide which one you should care about most? For starters, consider how your own money is invested. If your nest egg is 75% equities and 25% bonds, some simple math will give you a blended benchmark more appropriate than one that is 100% stocks. Own a strategy that is equal-weighted rather than market-cap weighted? If so, use an equal-weighted index as a reference.

International equities have lagged U.S. stocks for more than a decade, so you will need to compare the non-U. S. slice of your portfolio to a non-U. S. index to gauge whether you are outperforming or lagging.

Apples to apples is the key. Understand what you own and explore the tools you are measuring with, rather than using the first benchmark that comes to mind.

Finally, a reminder that tracking absolute performance is far less valuable without the context of financial planning. Every investor wants to beat the benchmark, but not every objective is best accomplished by prioritizing growth and ignoring volatility.

A well-built financial plan will help you understand if you are on track to reach your goals and whether recent performance has helped or hurt those chances. After all, peace of mind and financial independence are the ultimate benchmarks for investment success.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

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