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Investors look to broad indexes as benchmarks to help them gauge not only how well the markets are performing, but also how well they, as investors, are performing. For those who own stocks, they look to indexes like the S&P 500, the Dow Jones Industrial Average (DJIA) and the Nasdaq 100 to tell them "where the market is". The values of these indexes are displayed every day by financial media outlets all over the world. Most investors hope to meet or exceed the returns of these indexes over time. The problem with this expectation is that they immediately put themselves at a disadvantage because they are not comparing apples to apples. Read on to find out how you can use indexes to give your expectations and results a proper framework as you strive to achieve your investing goals. (To read more about indexes, see The ABCs Of Stock Indexes and our Index Investing Tutorial.)

TUTORIAL: Index Investing

What the Statistics Say
According to the January 2006 edition of Standard & Poor's "Indices Versus Active Funds Scorecard", the majority of actively managed funds - more than half of certain fund classes - do not beat the S&P 500 (in any one particular year or even over the last five years). They also state that most investors who trade their own portfolios lag the S&P as well. There are many reasons for why one particular fund would over- or underperform in a given year, but a few key reasons explain why most funds cannot outperform their indexes.

Investors always are incurring various amounts of what are known as frictional costs - trading costs, loads, commissions and capital gains taxes - all of which must be paid when they move in, out or around a fund or portfolio. Investors even incur frictional costs while they're simply holding the stocks in the form of management fees and account fees. However, the S&P no frictional costs. When used as a benchmark, it is an imaginary bucket of stocks held in a free portfolio with no trading costs and no capital gains taxes! In other words, the S&P 500 and other indexes, when used as benchmarks, are not subject to the same conditions as the investments in your portfolio, making it harder for you to outperform them.(To learn more about frictional costs, see Don't Let Brokerage Fees Undermine Your Returns and A Long-Term Mindset Meets Dreaded Capital-Gains Tax.)

Now all of this doesn't mean that the indexes are useless when looking at your own performance. Indexes are still an extremely valuable tool for investors to use for gauging the overall health of large public markets. Each index tells us a story about the assets it comprises. It smooths out what would otherwise be endless financial noise, day after day. What an index often fails to do, however, is show the performance results of any kind of a real portfolio. While many investors are already aware of this to some degree, it's the understanding and application of the tenet that counts - not just the knowledge.

The Power of Compounding
So what does this all add up to, you say? There is a quote you may find useful when explaining the nature of investment performance: "The most powerful force in the universe is compound interest." The man who said this? A moderately successful thinker named Albert Einstein. Let's for a moment, consider two portfolios, each of which begins investing on the same date with the same amount of money 20 years ago:

Portfolio 1 (Rob: 11%) - Beginning Value = $100,000
Portfolio 2 (Alice: 12.5%) - Beginning Value = $100,000

End of Period Values (20 years later):

Portfolio 1 (Rob's): $806,231.15
Portfolio 2 (Alice's): $1,054,509.38

Why such a large difference in ending values? Because Bob earned an annualized 11% return and Alice earned a 12.5% return. That's it - a 1.5% difference came to a cumulative difference of more than $200,000! And if we consider that a 1.5% drag on returns is a conservative estimate of the frictional costs that investors pay every year, we can quickly see how important it is to understand these costs and to keep them as low as possible. (To learn more about compounding interest, see Understanding The Time Value Of Money.)

Be Proactive with Little Steps
If you own mutual funds, learn where to look in your literature for accurate performance results, and keep an eye out for figures that are net of management fees and expenses. This will give you a more accurate measure of the fund's performance. When researching mutual funds, always be aware of the full expense ratio - a ratio in excess of 2% is a very costly fund, and it creates an uphill battle for the investor from the get-go. (For more insight, see Digging Deeper: The Mutual Fund Prospectus.)

A useful investing exercise is to always be expanding your awareness of what constitutes a good benchmark. The best benchmarks are representative of your actual holdings in terms of investing style and cost. There are literally thousands of possible benchmarks out there, so no matter what the composition of your individual portfolio is, you should be able to find one or two meaningful benchmarks to help you learn from your results and effectively plan for the future. Try looking at some of these to expand your arsenal:

Lipper Indexes - These are great for mutual fund investors. The Lipper Index for each style represents an average of the 30 largest mutual funds in that category. So, for example, the Lipper Large-Cap Index represents the 30 biggest large cap mutual funds, where largest is determined by the asset size of the fund.

MSCI Indexes - These Morgan Stanley indexes are good benchmarks for international investors; they show performance across many international countries and regions. Considering the inherent difficulty in finding good international benchmarks, the MSCI set is a well-maintained and respected benchmark.

Sector SPDRs (spiders) - The results of these sector-themed ETFs can be very useful for examining the performance of a particular sector, either for a mutual fund holder or a do-it-yourself investor.

Other important areas - Bond benchmarks, or inflation, can be used to great effect in certain instances. For example, many investors are happy to just preserve the principal amount they have already earned while keeping up with inflation. Not every investor is looking for the increased volatility that comes with searching for higher returns.

Where to Go from Here
Investors should always focus first and foremost on proper asset allocation and diversification when investing. But benchmarks, however we define them, are a useful tool than can tell us how we are doing compared to a representative peer. By making some slight and prudent adjustments to your expectations surrounding performance returns, you can effectively compare relative returns and make adjustments to your portfolio strategy as needed, giving you the best chances to succeed in your goals.

It is important to not get too attached to the performance figures for the broad indexes. This is difficult because the indexes are so widely considered the official yardsticks of the equity markets. Working with proper benchmarks will keep your eye on the ball and on the costs you incur, and can be a trusted ally along your path to investment success.

To continue reading on the subject, see A Market By Any Other Name and What should I use as a benchmark for my small-cap stock portfolio?

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