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What the indices can tell you
No single index reflects the whole U.S. market. Measure the market by the index that mirrors your investments.
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What a market we have all suffered these past few years. Many of the indices are down considerably for both the 5- and 10-year averages. The Dow Jones Industrial Average and the Standard and Poor’s 500 Index 5-year annualized returns decreased by nearly 40% compared with the same returns for year-end 2000.
While the Russell 2000 Index, a small-cap barometer, was one of the few domestic equity indexes to generate a positive return in 2001, the 5-year annualized return of this Index still lost as much as 27% compared with year-end 5-year returns measured at year-end 2000.
Index determines perception
However, perception of how our markets fare depends heavily upon which index is used to measure market performance. For the past 2 years the Dow did considerably better than the S&P 500. Both are considered large-cap indexes, but they do not move in step. The figures we rely on as annualized returns are susceptible to gyrations of our equities markets, despite the fact that measuring performance over 5- and 10-year periods attempts to dampen short-term performance quirks.
Sometimes these figures can hide as much as they reveal. Stocks cannot lose more than 100%, so there is a limit to the size of any negative return. However, there is no limit to the upward trend of positive returns. This means there can be an upward bias in mean return compared to median return, and this upward bias may be particularly noticeable in shorter periods of time such as 1 year or less.
No single equity index can possibly provide an accurate gauge of our entire U.S. market. Each investor should measure the market in relation to that particular index that best mirrors his or her in vestments. This is why not all investors are simultaneously panicked or up set when markets correct. They each have a potentially unique piece of the market pie, and these pieces may perform much differently than the broader indices.
Share-weighted returns
Probably the best indication of how investors are doing is share-weighted returns. Share-weighted returns assign a greater weight to stocks with more shares outstanding. For example, General Electric will have a greater weighting than a company such as Delta Airlines.
Because the share-weighted average return is lower than the raw average return of stocks over the past year, it implies that widely owned (larger) companies performed poorly relative to companies with less stock outstanding (smaller companies). Obviously, when widely held firms perform poorly, more investors are affected. Our U.S. equity market is one in which a small percentage of companies account for a disproportionately large portion of total outstanding shares of stock.
Mutual funds
When comparing mutual funds to stocks, mutual funds show 77% with a negative 1-year return versus 45% of individual stocks with a negative return. Typically, the diversification provided by mutual funds prevents such a negative downside and is deemed safer by investors. However, because mutual fund managers own many of the same stocks, these funds were hammered across the board. Moreover, the majority of equity fund assets are tied to large-cap funds, and large-cap stocks took a beating in 2001. This was not a good year to be in the markets in general, but portfolio managers do not have a crystal ball. They invest for the long term and generally do not time markets.
Over a longer period of time, mutual funds tend to insulate investors from loss more effectively than a random sampling of individual stocks, but they also tend to have less stellar rates of return. Over a 10-year period, no equity funds had a negative annualized 10-year return. Extremes of performance, both up and down, are characteristic of individual stocks. Mutual funds tend to perform within more narrow performance parameters.
Does this mean that mutual funds are a better or safer investment? Not necessarily. While mutual funds provide some diversification, they also limit the upside potential of any investment. Fund managers are required to keep a certain percent of assets in cash, so they are never fully invested, even during a bull market.
Fund managers are required to raise cash should investors bail from the fund. This means the managers, through no fault of their own, might be forced to sell stocks during a bear market or short-term correction. Because limits are placed on the percent of assets held in any one stock, fund managers are also required to sell their star performers as the share price increases to prevent that particular stock from becoming a larger-than-allowable share of the overall portfolio.
Individual stocks
The investor with individual stocks can put more money to work during a bear market or correction without concern for a required cash reserve. He or she can hold those stellar performers or set stop-sell limits as they continue to move higher. They can hold a fewer number of quality stocks. While these possibilities allow the individual investor to reap much higher returns, it also means that investor should be willing to allow for greater risk and greater losses in a bear market or greater correction.