One standard way to measure performance, whether
of an individual security or a portfolio of securities, is to
compare it to the appropriate benchmark: the S&P 500-stock
Index for large-cap stocks, the Russell 2000 for small-cap stocks,
or the Dow Jones 20 Bond Average for high-grade corporate bonds.
But benchmarks have limitations when you use them to assess and
manage risk.
Although indexes
record volatility, they are trailing indicators, which means
they report what has happened but not what is likely to happen.
While there is often a correlation between past and future
performance, there are no guarantees.
Most stock indexes,
because they are either capitalization-weighted or price-weighted,
are driven by the performance of a small percentage of the
total number of stocks in the index — those that are
either the largest or the most expensive. As a result, what
their movements show is not always indicative of, or even
relevant to, the larger group in the index, or to your own
portfolio.
A little square
To decide which index is the most appropriate for an individual investment, you can evaluate the extent to which an investment correlates with an index by researching its r-square. An r-square of 0 means there is no correlation at all, while 100 means there is perfect correlation.
Thomas J. Dorsey, President and
co-founder of Dorsey, Wright &
Associates
One standard way to measure performance, whether
of an individual security or a portfolio of securities, is to
compare it to the appropriate benchmark: the S&P 500-stock
Index for large-cap stocks, the Russell 2000 for small-cap stocks,
or the Dow Jones 20 Bond Average for high-grade corporate bonds.
Thomas J. Dorsey, President and
co-founder of Dorsey, Wright &
Associates 