Pay attention to financial news and you'll quickly realize that investing pros tend to measure our economy in terms of indexes: The Dow, for example, may be up 2% on a given day, or the S&P 500 may have fallen 30 points.
These indexes, which serve as important benchmarks for Wall Street, track the performance of hundreds, or even thousands, of companies. Watching them helps professional investors understand how the overall stock market, or specific sectors of it, are performing. Traders sometimes use the big ones, like the S&P 500 or the Dow Jones Industrial Average, as shorthand for the state of the entire economy.
There are also benchmarks that set the standard for investments ranging from small cap to bond funds. Even actively managed funds — which employ professional stock-pickers to select investments — use a comparison benchmark index to determine if their management is providing better returns than the overall market.
All this can be confusing for individual investors, as many people try to measure the performance of their portfolios against that of a broad index like the S&P 500 or the Dow. Here's a closer look at how to think about what these benchmarks do, and don't, mean in relation to your own investments.
Over the past century, the S&P 500 has seen average annual returns of just over 10%. But don't assume your portfolio is falling short if it doesn't match that average in a given year. Here's what to keep in mind to better understand how your portfolio is doing.
- The S&P 500's 10% benchmark is a long-term average. Since 2000, annual returns have been as high as 29.6% (in 2013), and as low as -38.5 (during the Great Recession, in 2008). So far in 2019, the S&P 500 is currently up about 16% — but that's after starting the year down pretty substantially from 2018's highs. It also doesn't account for inflation, or the amount prices for goods and services rise from year to year. With inflation, long-term S&P 500 averages drop to just over 7%. Not quite as high, but still substantially higher than the 0.09% averages for savings accounts and the average 2% inflation rate.
- Your portfolio probably contains more than just an S&P 500 index fund. In fact, ideally it contains a mix of funds, each with their own benchmark: small and large cap, domestic and international, developed and emerging markets. Your portfolio composition also may include a greater percentage of bond funds, which have historically offered smaller, but more stable, returns. This kind of diversification aims to give you a steadier ride than if you invested in any one fund alone. For example, if domestic stocks are down, international stocks may be up, so having a mix of investment types in your portfolio can help it maintain its value and grow consistently over time.
- Fees eat into your investment returns. Even if you invest in a fund tracking the S&P 500, you may not see quite the performance of the benchmark. That's because it costs money to run an investment fund: Think trading fees and the salary of the person making those trades to keep the fund in line with the index. Still, index funds generally offer the cheapest, most efficient way to match the overall market's performance. In 2018, the average expense ratio for such passive funds was 0.15%, compared to 0.67% for actively managed funds, according to Morningstar.
The bottom line: Benchmarks provide a good way of measuring the overall health of your investments' performance, so long as you understand that it's very hard to consistently meet, let alone beat, them.
Your portfolio doesn't need to, and probably won't, exactly match a benchmark's performance, and that's OK. A diversified portfolio will contain a mix of assets optimized for steady upward performance.
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