Average returns are the simple mathematical average of a series of returns generated over a period of time. An average return is calculated the same way a simple average is calculated for any set of numbers; the numbers are added together into a single sum, and then the sum is divided by the count of the numbers in the set.
For example, suppose an investment had returned the following annual returns over a period of five full years: 10%, 15%, 10%, 0% and 5%. To calculate the average return for the investment over this five-year period, the five annual returns would be added together and then divided by five. This produces an annual average return of 8%.
Variability Of Returns
Seeking average returns rather than trying to beat the market is a widely recommended investment strategy. We'll explain why this is the case in a later section, Capital Market Efficiency. For now, let's assume you want to follow this advice and seek average returns. How do you do it?
First, you must define which average you're trying to achieve. To do this, you need to find an index - an imaginary portfolio of securities - that mimics the portion of the market you'll be investing in. If you're investing in the entire S&P 500, an S&P 500 index will tell you how that segment of the market has performed over a given time period.
On July 3, 1884, Dow Jones & Company published its first stock average index. Founded in 1882 by Charles Dow, Edward Jones and Charles Bergstresser, Dow Jones & Company's mandate was to provide easy-to-understand stock averages for the everyday investor. Beginning with the first index in 1884, Dow Jones published the now well-known Dow Jones Industrial Average (DJIA), commonly referred to as "The Dow," in 1896. The Dow consists of 30 of the most significant stocks in the United States and is one of the most widely used indexes on Wall Street. (Read The Top Position Holders In The DJIA to learn more about the modern Dow.)
Along with the DJIA, the Standard & Poor's 500 is one of the world's best known indexes, and is the most commonly used benchmark for the stock market. Other prominent indexes include the DJ Wilshire 5000 (total stock market), the MSCI EAFE (foreign stocks in Europe, Australasia, Far East) and the Barclays US Aggregate Bond Index (total bond market).
Technically, you can't actually invest in an index, but index mutual funds and exchange-traded funds (based on indexes) make it possible to invest in securities representing broad market segments and/or the total market.
Average returns can be defined very broadly or more narrowly. The average return for the S&P 500 will differ from the average return for technology stocks. Likewise, the average return for the total bond market will differ from the average return on U.S. Treasury notes. The time period under consideration also influences average returns. For example, while the stock returned an average of 11.31% from 1928 through 2010, it returned an average of 3.54% from 2001 to 2010.
Index investing is a form of passive investing that aims to generate the same rate of return as an underlying market index, no matter how low or how high that return is. Investors that use index investing seek to replicate the performance of a specific index - generally an equity or fixed-income index - by purchasing shares of an investment vehicle such as index funds or exchange-traded funds that closely track the performance of these indexes.
Proponents of index investing eschew active investment management because they believe that it is impossible to "beat the market" once trading costs and taxes are taken into account. As index investing is relatively passive, index funds usually have lower management fees and expenses than actively managed funds. Lower trading activity may also result in more favorable taxation for index funds as compared with actively managed funds.
It is hard to believe that indexes have been around for less than half the history of stock exchanges. In this section we will look at the history of these investment vehicles.
It's not unusual for people to talk about "the market" as if there were a common meaning for the word. But in reality, the many indexes of the differing segments of the market don't always move in tandem. If they did, there would be no reason to have multiple indexes. By gaining a clear understanding of how indexes are created and how they differ, you will be on your way to making sense of the daily movements in the marketplace. Here we'll compare and contrast the main market indexes so that the next time you hear someone refer to "the market," you'll have a better idea of what they mean.
If you ask an investor how "the market" is doing, you might get an answer that is based on the Dow. The Dow Jones Industrial Average (DJIA) is one of the oldest, most well-known and most frequently used indexes in the world. It includes the stocks of 30 of the world's largest and most influential companies. The DJIA is what's known as a price-weighted index. It was originally computed by adding up the per-share price of the stocks of each company in the index and dividing this sum by the number of companies - that's why it's called an average. Unfortunately, it is no longer this simple to calculate. Over the years, stock splits, spin-offs and other events have resulted in changes in the divisor, making it a very small number (less than 0.2).
The DJIA represents about a quarter of the value of the entire U.S. stock market, but a percent change in the Dow should not be interpreted as a definite indication that the entire market has dropped by the same percent. This is because of the Dow's price-weighted function. The basic problem is that a $1 change in the price of a $120 stock in the index will have the same effect on the DJIA as a $1 change in the price of a $20 stock, even though one stock has changed by 0.8% and the other by 5%.
A change in the Dow represents changes in investors' expectations of the earnings and risks of the large companies included in the average. Because the general attitude toward large-cap stocks often differs from the attitude toward small-cap stocks, international stocks or technology stocks, the Dow should not be used to represent sentiment in other areas of the marketplace. On the other hand, because the Dow is made up of some of the most well-known companies in the United States, large swings in this index generally correspond to the movement of the entire market, although not necessarily on the same scale. (For more information on this index, see Calculating The Dow Jones Industrial Average.)
The S&P 500 [E1]
When investors say that their portfolios have "beaten the market," they are usually referring to the performance of the S&P 500. The Standard & Poor's 500 Stock Index is a larger and more diverse index than the DJIA. Made up of 500 of the most widely traded stocks in the United States, it represents about 70% of the total value of U.S. stock markets. In general, the S&P 500 index gives a good indication of movement in the U.S. marketplace as a whole.
Because the S&P 500 index is market weighted (also referred to as capitalization weighted), every stock in the index is represented in proportion to its total market capitalization. In other words, if the total market value of all 500 companies in the S&P 500 drops by 10%, the value of the index also drops by 10%. A 10% movement in all stocks in the DJIA, by contrast, would not necessarily cause a 10% change in the index. Many people consider the market weighting used in the S&P 500 to be a better measure of the market's movement because two portfolios can be more easily compared when changes are measured in percentages rather than dollar amounts. (To learn more, check out Market Capitalization Defined and How is the value of the S&P 500 calculated?)
The S&P 500 index includes companies in a variety of sectors, such as energy, industrials, information technology, healthcare, financials and consumer staples.
The Wilshire 5000
The Wilshire 5000 is sometimes called the "total stock market index" or "total market index" because it includes more than 7,000 of the 10,000-plus securities that are publicly traded in the United States. All publicly-traded companies with headquarters in the United States that have readily available price data are included in the Wilshire 5000. Finalized in 1974, this index is extremely diverse, including stocks from every industry. Although it's a near-perfect measure of the entire U.S. market, the Wilshire 5000 is referred to less often than the less comprehensive S&P 500 when people talk about the entire market.
The Nasdaq Composite Index
Most investors know that the Nasdaq is the exchange on which technology stocks are traded. The Nasdaq Composite Index is a market-value-weighted index of all stocks traded on the Nasdaq stock exchange. This index includes more than 5,000 companies, including some that are not based in the United States. Although this index is known for its large portion of technology stocks, the Nasdaq Composite also includes stocks from financial, industrial, insurance and transportation industries, among others. The Nasdaq Composite includes large and small firms but, unlike the Dow and the S&P 500, it also includes many speculative companies with small market capitalizations. Consequently, its movement generally indicates the performance of the technology industry as well as investors' attitudes toward more speculative stocks. (For further reading, see What is the difference between the Dow and the Nasdaq?)
The Russell 2000
The Russell 2000 is a market value weighted index of the 2,000 smallest stocks in the Russell 3000, an index of the 3,000 largest publicly-traded companies, based on market cap, in the U.S. stock market. The Russell 2000 index gained popularity during the 1990s, when small-cap stocks soared and investors moved more money to the sector. The Russell 2000 is the best-known indicator of the daily performance of small companies in the market. It is not dominated by a single industry.
It's good to know what's going on in the many diverse segments of the U.S. and international markets. If you're going to pick just one index or market to talk about, however, you can't go wrong with the S&P 500, which offers a good indication of the movements in the U.S. market in general. By watching indexes and keeping track of their movements over time, you can get a good handle on the investing public's general attitude toward companies of all different sizes and from varying industries.
Index funds have provided investors with a return that is directly linked to individual markets while charging minimal amounts for expenses. Despite their benefits, not everyone seems to know exactly what index funds are and how they compare to the many other funds offered by different companies.
Active and Passive Management
Before we get into the details of index funds, it's important to understand the two different styles of mutual-fund management: passive and active.
Most mutual funds fit under the active management category. Active management involves the art of stock picking and market timing. This means the fund manager will put his/her skills to the test trying to pick securities that will perform better than the market. Because actively managed funds require more hands-on research and because they experience a higher volume of trading, their expenses are higher.
Passively managed funds, on the other hand, do not attempt to beat the market. A passive strategy instead seeks to match the risk and return of the stock market or a segment of it. You can think of passive management as the buy-and-hold approach to money management.
What Is an Index Fund?
An index fund is passive management in action: it is a mutual fund that attempts to mimic the performance of a particular index. For instance, a fund that tracks the S&P 500 index would own the same stocks as those within the S&P 500. It's as simple as that! These funds believe that tracking the market's performance will produce a better result compared to the other funds.
What Benefits Are They Providing?
There are two main reasons why somebody chooses to invest in an index fund. The first reason is related to an investing theory known as the efficient market hypothesis. This theory states that it is impossible for investors to gain above-average returns because all relevant information that may affect a stock's price is already incorporated within its price. Thus, index fund managers and their investors believe that if you can't beat the market, you might as well join it.
The second reason to choose an index fund is the low expense ratios. Typically, the range for these funds is around 0.2-0.5%, which is much lower than the 1.3-2.5% often seen for actively managed funds. But the cost savings don't stop there. Index funds don't have the sales charges known as loads, which many mutual funds have.
In bull markets when returns are high these ratios are not as noticeable for investors; however, when bear markets come around, the higher expense ratios become more conspicuous as they are directly deducted from meager returns. For example, if the return on a mutual fund is 10% and the expense ratio is 3%, then the real return to the investor is only 7%.
What Are You Missing Out On?
One of the major arguments of active managers is that, by investing in an index fund, investors are giving up before they have even started. As an index fund will always earn a return identical to that of the market it is tracking, index investors will not be able to participate if any anomalies occur. For instance, during the tech boom of the late '90s, when new technologies companies reached record highs, index funds were unable to match the record amounts of some actively-managed funds. (For additional reading, see How To Calculate Your Investment Return and Achieving Better Returns In Your Portfolio.)
What Are the Results?
Generally, when you look at mutual fund performance over the long run, you can see a trend of actively-managed funds underperforming the S&P 500 index. A common statistic is that the S&P 500 outperforms 80% of mutual funds. While this statistic is true in some years, it's not always the case.
A better comparison is provided by Burton Malkiel, the man who popularized efficient market theory in his book "A Random Walk Down Wall Street." The 1999 edition of his book begins by comparing $10,000 investment in the S&P 500 index fund to the same amount in the average actively-managed mutual fund. From the start of 1969 through to June 30, 1998, the index investor was ahead by almost $140,000: her original $10,000 increased 31-times to $311,000, while the active-fund investor ended up with only $171,950.
Are Index Funds Better?
It's true that over the short term some mutual funds will outperform the market by significant amounts. But picking the good funds out of the thousands that exist is almost as difficult as picking stocks yourself! Whether or not you believe in efficient markets, the costs in most mutual funds make it very difficult to outperform an index fund over the long term. (To learn more about index investing, read our Index Investing Tutorial, The ABCs Of Stock Indexes and How Stock Market Indexes Changed Investing.)