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FP513: Module 7.3 Indicators of Security Returns

Terms in this set (12)

Averages and Indices
constructed to inform investors about changes in the market and serve as benchmarks for the performance of investors' portfolios and the performance of money managers, such as mutual fund money managers
Price-weighted index
stock market index in which stocks are held in proportion to their share price

*higher-priced stocks within this index have more influence on the overall movement of this index than lower-priced stocks
Market capitalization-weighted index
a type of stock market index where individual components of the index are included in amounts that correspond to their total market capitalization

A company's market capitalization is calculated by multiplying its outstanding shares by the current price of a single share. (Outstanding shares are those owned by individual shareholders, institutional block holdings, and company insider holdings.) In this way, market capitalization reflects the total market value of a firm's outstanding shares.

This type of index is also known as a market value-weighted index
Dow Jones Industrial Average (DJIA)
a price-weighted index of 30 representative stocks used to monitor price changes in the overall stock market

despite the shortcomings of using this index, it is highly correlated with other broader market indices such as the S&P 500.

correlation coefficient of this index and S&P 500 is greater than 95% which indicates that this is still an adequate representation of the market in spite of its fundamental weaknesses.
Shortcomings of using the Dow Jones Industrial Average (DJIA)
this index:
1) fails to reflect payment of cash dividends

2) fails to ignores stock dividends of less than 10%,

3) fails to account for the number of shares outstanding

4) it only consists of a biased sample of stocks (mostly blue chip companies)

5) are more influenced by higher-priced stocks than lower-priced stocks
S&P 500 Index
a market capitalization-weighted index that compromises of 500 different stocks from the NYSE and the NASDAQ and includes only large cap companies.

Determined by summing the market capitalization value of the 500 companies, dividing by the base year value, and then multiplying this amount by 10.

Automatically adjusts for stock splits and dividends by focusing on the market capitalization values instead of the individual stock share prices of each of the 500 companies within the index.

This index is used by most professionals as a benchmark for US large-cap equity investments and is composed of industrial stocks, transportation stocks, utilities and financial institutions.
Russell 2000 index
used to benchmark small-capitalization companies

This index is a market capitalization-weighted index and is a subset of the Russell 3000 index, which represents most U.S. equities
The MSCI EAFE Index (Morgan Stanley Capital International Europe, Australasia, and Far East)
created as a measure of the international securities markets

index that provides an indication of how a portfolio consisting of companies outside the United States might perform over time and is probably the most well-known measure of international stocks.
Wilshire 5000 Index
consists of over 5,000 US-based companies and is often used as a measure of the overall market within the US
J.P. Morgan Indices
track emerging markets, government debt and corporate asset classes
Evaluating Performance using indices and averages
No single index is so comprehensive as to include even the short list of asset classes identified previously. Several world indices do exist in the stock and bond asset classes that could be used, but even a comparison against these indices might not be realistic.

A more realistic approach might be to create a dollar-weighted portfolio index using the indices against which each asset class is being measured. A consistent method of measuring each asset class and the entire portfolio would then be available.

Capitalization-weighted indices are used in modern portfolio theory, since they most accurately reflect what is happening in the market.

*You should strive to make as accurate a comparison as possible when comparing a portfolio against a benchmark. This normally entails coming up with a blended benchmark. Comparing a client's entire portfolio return against just the S&P 500 return if only 30% of the portfolio is invested in U.S large cap stocks is not prudent.
When using a security market index to represent a market's performance, the performance of that market over time is best represented by
Percentage changes in the value of a security market index over time
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