Tuesday, September 15, 2009

Don't Use the Dow as Your Benchmark

Every investor needs a benchmark. It is important because without some sort of proxy, you will never really know how you are performing. To put it simply, if your portfolio is not beating the overall stock market then you are doing something very wrong and you need to adjust your strategy. Typically, most investors use one of three choices for a benchmark.

The choices are either an ETF or other product that tracks the market using an asset allocation that closely matches your own asset allocation, the S&P 500 or the Dow Jones. Many investors pick the Dow simply because it is very visible in newspapers and other financial media. However, I do not think the Dow is a good proxy to the market and many investors would be better off choosing something like Vanguard's Balanced Index Tracking ETF (VBINX) or even the Russell 1000 or the Wilshire 5000.

Here is why I believe the Dow should not be uses as an investment benchmark:

1. Small Number of Stocks

The Dow only has 30 stocks while the whole market has thousands. No matter how big those companies are or how important they are to the economy, there is no way they can be an accurate representation of the entire market.

2. Stocks are Weighted to Price and Not Market Cap

What this means is that the higher priced stocks in the index tend to move it more than the others. Is a higher share price actually a better company than another one? I do not think so.

3. Stocks Seem to Move In and Out After the Fact

I have really noticed that after the sh$t hits the fan the companies tend to exit the index. Same for when they come it - after the company has skyrocketed. Stick to benchmarks that are more broad and you lose this issue.

4. A Committee Picks Who is In and Who is Out

Some dudes in a room somewhere decide which stocks are in and out of the index. Sounds like active investing to me! I am sure the process is much more pragmatic than it seems, but the stocks in the index seem to be the opinion

Overall, I do not use the Dow to judge how I am doing against the market. I actually use the VBINX as it closely resembles my overall asset allocation (60/40). I feel it is a better proxy with which to judge how I am doing.

This article was written by The Dividend Guy. You may email questions or comments to me at info@thedividendguyblog.com.

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