January 2008

Investors who have diversified portfolios can find it difficult to compare their performance to that of “the market.”

That’s because no one index adequately reflects a portfolio that is invested in domestic and international stocks and bonds.

The most common reference point for unsophisticated investors is the Dow Jones Industrial Average, probably because it is long-established and widely followed by the financial press.

You have to pick the appropriate mix of indexes if you want a true comparison of the performance of a diversified portfolio to the market.

The Dow, however, reflects the performance of only 30 big U.S. stocks, a small fraction of the tens of thousands of domestic and foreign stocks and bonds that make up the world’s investment markets.

That makes it possible for the Dow to go through periods when it does better—or worse– than the great mass of investable stocks, because the performances of a handful of its components can influence its movement.

Another widely-followed index, the NASDAQ, mainly reflects the performance of large stocks in technology businesses. It, too, can differ radically from the broader stock market.

A more appropriate—but still not perfect– gauge of the U.S. stock market is the Standard & Poor’s 500 Stocks Index.

As its name implies, it represents the fortunes of the 500 largest publicly traded stocks in the United States.

Although it leaves out thousands of smaller stocks, the stocks it covers account for close to 90% of U.S. stock market value.

But the S&P 500 is only reasonable when compared to a portfolio comprised primarily of large U.S. stocks.

If you own smaller stocks, then the S&P 500 may not tell you how they are doing, because they can move very differently from large stocks.

Meanwhile, including foreign stocks in a portfolio complicates comparisons further. Although foreign markets often move in tandem with the U.S. market in the short term, they can differ strongly over longer periods. Consider the year 2007, when U.S. stocks barely rose at all but stocks issued in emerging foreign economies posted double digit gains.

Finally, a portfolio that includes bonds is likely to look better than a stock market index in bad times and not as good when the stock market is rising.