Understanding Stock Market Indexes

Jane Young, CFP, EA

Jane Young, CFP, EA

A stock market index provides a benchmark from which you can measure the performance of the stock portion of your portfolio.  An index statistically tracks the movement of a specific grouping of stocks.  There are numerous indexes that range from monitoring performance of the entire market to specific sectors of the market.  When referencing an index it’s important to understand what comprises the index and how the stocks are weighted.

The oldest and most widely followed index is the Dow Jones Industrial Average (DJIA), founded on May 26, 1896 by Charles Dow.  It is comprised of 30 stocks from a wide range of industries with the exception to transportation and utilities.  The 30 stocks comprising the index are selected by editors of the Wall Street Journal with the goal to show a true reflection of the market by focusing on relevance, longevity and market representation.

The DJIA isn’t actually an index but a price weighted average where more expensive stocks represent a higher proportion of the index and have more influence on the movement of the index than lower priced stock.  Originally, the DJIA was an average of the sum of the prices on all stocks in the index divided by the total number of stocks.  However, over time the calculation has been adjusted to account for stock splits and dividends.

Currently the DJIA represents about 25% of the total value of the U.S. stock market.  Although it only represents 30 widely known companies, over the long term it tracks well with the S&P 500 and can be a good measure of large company stock performance.

The S&P 500, another widely known index, was created on March 4, 1957 by Standard and Poor’s and is now part of McGraw Hill Financial.  It is comprised of 500 U.S. companies chosen by a committee at Standard and Poor’s with an objective to represent the U.S. stock market based on “market size, liquidity and group representation”.  It excludes companies that invest in real estate and companies that primarily hold stock in other companies.  Currently the index is solely comprised of U.S. companies, primarily but not limited to large companies.  The S&P represents about 75% of the value of the U.S. Stock Market, providing a much broader picture than the DJIA.

The S&P 500 is a market-cap weighted index where the weight in the index is based on the total value of all outstanding stock in the company.  As a result, large companies have much greater influence on movement in the index than do small companies.  About 50 of the 500 stocks in the index represent half of the total market capitalization within the index.

There are numerous other indexes available to monitor performance on specific sectors, smaller company stock and international stock.  For example, the Wilshire 5000 Index is a total U.S.  market index covering almost all publicly traded U.S. companies and the Russell 2000 Index covers the 2000 smallest publicly traded U.S. companies – both of which are capitalization weighted.

Words of Wisdom from Planners Around the Country

Jane Young, CFP, EA

Jane Young, CFP, EA

While recently attending the national conference of the Alliance of Comprehensive Planners, I interviewed dozens of fee-only, Certified Financial Planners.  I asked them to share the most important piece of advice that they can give to their clients.  The answers were not exciting or complicated but practical, common sense recommendations that are useful to most everyone.   The most common piece of advice, by an overwhelming margin, was to save more and spend less.  Below are the top ten most important financial steps you should take according to some of the finest financial planners in the industry.

  1. Live Below Your Means – Establish good spending habits early. Monitor your expenses for about three months and create a realistic spending plan that you can stick with.  Make intentional decisions to keep your spending well below your income and always maintain an emergency fund.
  2. Save at Least 10% of your Gross Income – Start saving as early as possible. Everyone should save at least 10% of their income.  If you are getting started later you may need to save closer to 15% to 20% of your income
  3. Look at the Big Picture – Take an integrated approach to your finances. Your financial life is a big puzzle with a lot of interlocking pieces.   Don’t make decisions in isolation.  Create a financial plan that serves as a roadmap to integrate all areas of your financial life including investments, taxes, insurance, retirement planning and estate planning.
  4. Be True to Yourself – Live, spend, and invest in accordance to your values and goals, not to impress or compete with others.
  5. Create a Realistic Investment Plan – Create a diversified investment plan that you will stick with during significant market fluctuations. Your portfolio needs to support your investment time horizon and the level of risk that you are comfortable with.
  6. Hire a Good Financial Planner – Managing your finances can be more complicated and time consuming than you realize. A financial planner can help you integrate all aspects of your financial life and can provide an objective perspective on your situation.
  7. Don’t Invest in Complex Insurance and Investment Products – Avoid insurance and investment vehicles that require a team of attorneys to understand. The words in small print are probably not in your best interest.
  8. Maximize Contributions to your 401k and Roth IRA – Fully utilize tax advantaged retirement plans and take advantage of an employer match where available.
  9. Don’t Let Family Members Derail Your Financial Plan – Don’t sabotage your financial security by paying for all of your child’s college education or by supporting adult children, parents, or siblings. You need to help yourself before you can be of assistance to others.
  10. Leverage Your Real Estate – Don’t be in a hurry to pay off a low interest mortgage on your personal residence. You can benefit from appreciation on your home with as little as 10% to 20% down.

Value Provided by Financial Advisor Can Exceed Fee

Jane Young, CFP, EA

Jane Young, CFP, EA

Many things can trigger the decision to hire a financial planner.  You may need some direction on how to prioritize your spending and saving to better prepare for the future.  You may be too busy or uninterested in managing your own finances.   You may experience a sudden life change such as a marriage, divorce, inheritance or retirement.   Your situation may be getting complicated and you want a professional opinion or you lack the technical expertise to continue managing things on your own.

Although, you may need a financial planner you may be hesitant to pay the fee.   Fee-only planners can be compensated using a flat fee, a percentage of assets or an hourly rate.   The fee will typically be around 1% of assets for on-ongoing advice.   A recent Vanguard study may help put your mind at ease.   The study found that the added value provided by a fee-only planner can far exceed the cost.

In 2014 Vanguard published the results of a study they conducted on the value added by advisors.  The study found that financial advisors can add up to about 3% in net returns for their clients by focusing on a wealth management framework they refer to as Advisor’s Alpha©.  The study found that an advisor can add to a client’s net returns if their approach includes the following five principles: being an effective behavioral coach, applying an asset location strategy, employing cost effective investments, maintaining the proper allocation through rebalancing and implementing a spending strategy.  These are just a few of the practices and principles followed by most comprehensive fee-only planners.

The exact amount of added return will vary based on client circumstances and implementation.  It should not be viewed as an annual return but as an average over time.  The opportunity for the greatest value comes during periods of extreme market duress or euphoria.  Additionally, Vanguard found that paying a fee for advice using this framework can add significant value in comparison to what the investor had previously experienced with or without an advisor.

Vanguard’s framework places emphasis on relationship oriented services that encourage discipline and reason, in working with clients who may otherwise be undisciplined and reactionary.  Rather than focusing on short term performance there is a focus on sticking to the plan and avoiding emotional overreaction. Advisors, acting as behavior coaches, can help discourage clients from chasing returns and focus instead on asset allocation, rebalancing, cash flow management and tax-efficient investment strategies.

The study found that when advisors place emphasis on stewardship and a strong relationship with the client, investors were less likely to make decisions that hurt their returns and negatively impacted their ability to reach long term financial goals.  According to Vanguard “Although this wealth creation will not show up on any client statement, it is real and represents the difference in clients’ performance if they stay invested according to their plan as opposed to abandoning it.”

Financially Get a Jump Start on 2017

office pictures may 2012 002The beginning of a new year is a good time to evaluate your finances and take steps to improve your financial situation.  Start by reviewing your living expenses and comparing them to your income.  Are you living within your means and spending money in areas that are important to you?  Look for opportunities to prioritize your spending where you will get the most benefit and joy.

This is also a good time to calculate your net worth to see if it has increased over the previous year and evaluate progress toward your goals.  To calculate your net worth, add up the value of all of your assets including real estate, bank accounts, vehicles and investment accounts and subtract all outstanding debts including mortgages, credit card balances, car loans and student loans.

With a better understanding of your net worth and cash flow you are ready to set some financial goals.  Start with the low hanging fruit including paying off outstanding credit card balances and establishing an emergency fund.  Maintain an emergency fund equal to at least three months of expenses.   Once your credit cards are paid off you may want to focus on paying off other high interest debt.

After paying off debt and creating an emergency fund, it’s advisable to get in the habit of saving at least 10% of your income.   Saving 20% may be a better goal if you are running behind on saving for retirement.

Take advantage of opportunities to defer taxes by contributing to your company’s 401k.  If you are self- employed create a retirement plan or contribute to an IRA.  Take advantage of any match that your employer may provide for contributing to your retirement plan.  If you are already making retirement contributions, evaluate your ability to increase your contributions.  If you have recently turned 50 you may want to increase your contribution to take advantage catch-up provisions that raise the contribution limits for individuals over 50.

As the new year begins you also may want to evaluate your career situation.  Saving and investing is just part of the equation, your financial security is largely dependent on career choices.  Look for opportunities to enhance your career that may result in a higher salary or improved job satisfaction.  It may be time to ask for a raise or a promotion or to explore opportunities in a new field.  Consider taking some classes to sharpen your skills for your current job or to prepare you for a new more exciting career.

You may have additional goals such as buying a new home, contributing to your children’s college fund, remodeling your house, or taking a big vacation.  Strategically think about your priorities and what will bring you satisfaction.  Start the year with intention, identify some impactful financial goals and create a plan.  Formulate an action plan with specific steps to help you meet your goals.

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