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.

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.

Risk and Your Investment Portfolio – Part 1

 

Jane Young, CFP, EA

Jane Young, CFP, EA

Deciding upon an asset allocation is one of the first and most significant decisions to be made when you start investing.  Your asset allocation is the percentage of different types of investments such as cash, bonds, stock or real estate that make up your investment portfolio.  Probably one of the most important allocations is that between investments in the stock market and investments in interest earning vehicles such as bank accounts, CDs and bonds.  An ideal asset allocation provides a balance between risk and return that helps you meet your goals but doesn’t keep you awake at night.

There is a trade-off between risk and return.  Generally, if you want a higher return you need to assume a higher level of risk.  Investment risk comes in many different forms with the most common being stock market risk.  Historically, over long periods of time, the stock market has out-performed most other investments.  However, in the short term it can be extremely volatile, including years with negative returns.  In the extreme case you could lose your entire investment in an individual stock.  To reduce risk in the stock portion of your portfolio, consider buying diversified stock mutual funds. You will still experience swings in the market but fluctuations in any one stock will have less impact.

On the other hand, interest earning investments such as bank accounts, CDs, bonds and bond funds are generally less risky and are not subject to stock market fluctuations.  Unfortunately, in exchange for this lower level of risk you may earn a much lower rate of return.

Additionally, bonds and bond funds are subject to interest rate risk and default risk.  If you purchase a bond or bond fund and interest rates increase, the value of your investment will decrease.  To make matters worse, when interest rates rise bond funds commonly experience a flood of redemptions forcing them to sell bonds within the fund at a loss.  Even if you hold on to your shares you can experience a drop in value. However, if you purchase an individual bond and hold it till maturity you will receive the full value upon redemption.   Use caution when buying low quality bonds or bond funds; you may get a higher return but you are subject to a much greater risk of default.

Many investors don’t consider inflation risk.  This results from taking too little risk with a conservative portfolio containing little or no stock.  Over time inflation has averaged about 3% annually, if you are only earning 2% on your portfolio your real return after inflation will be negative.  This is compounded if inflation rates rise significantly.  Consider increasing your allocation in the stock market to hedge against inflation risk.

In the current environment of low interest rates and high volatility it’s crucial to build a portfolio that balances risk and return to support your financial goals and provide you with peace of mind.

Variable Annuity Not Magic Solution

office pictures may 2012 002While driving home recently I was disconcerted by another commercial spouting false information and preying on investor fear.  This commercial was exaggerating the danger and volatility of the stock market by implying most investors lost millions in the 2008 and 2009 market crash.  In reality if you were invested in the stock market from 2006 to 2016 you would have seen a 65% increase in your stock portfolio.  If you didn’t sell when the market dropped, you would have experienced a reasonable return rather than a loss on your investment.   Commercials like this stir up fear and anxiety then promise the perfect solution to market volatility – the magic to provide great returns without taking risk.

There is no miracle product that is going to provide you with high returns without risk.  If it sounds too good to be true, it is!  A basic concept of investing is the trade-off between risk and return.  If you want more return you will have to absorb greater risk.  If you want a risk free investment you will be limited to CD’s and US government bonds that pay very low interest rates.   If you want to earn higher returns you will need to take on some risk and invest part of your portfolio in the stock market.

The mystery product in commercials and ads that promise high returns with no risk is often a variable annuity.  While on occasion the use of an annuity may be appropriate for a portion of your portfolio, most variable annuities come with significant disadvantages.   A variable annuity is an insurance vehicle that invests your money into separate accounts similar to mutual funds.   Annuities are complex insurance contracts that are commonly sold on commission, with built-in fees and significant restrictions on when and how you can withdraw your money.    Earnings on money invested in a variable annuity grow tax deferred but are taxed at regular income tax rates when withdrawn.

Insurance salespeople influence you to buy annuities by promising protection from market volatility.  Basically, in addition to paying the typical fees and commissions, you can purchase an insurance rider to guard against a drop in the market.  However, this insurance usually only applies to a death benefit or the base amount used to calculate an annual income stream.   If you think a variable annuity is appropriate for your situation make sure you fully understand the product’s benefits and restrictions before investing.   Also consider an annuity with no or a low commission and without restrictions on when and how you can access your money.

A better option for managing market volatility may be to invest in a diversified portfolio that supports your time horizon.   Avoid the need or temptation to withdraw money from the stock market when it’s down.  Invest money needed in the short term in safe investments and limit your stock market investments to long term money.

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