How to Measure Your Stock Market Performance

To gauge how well your stock portfolio is doing, you need to compare it to a benchmark. Familiarity with commonly-used benchmarks (i.e. indexes) can help you make apples-to-apples comparisons.

Standard & Poor’s 500 Composite Index
The S&P 500 is a market-value-weighted index of 500 widely held large-cap U.S. common stocks. A committee decides which companies are represented in the index, based on each one’s market cap ($4 billion plus), liquidity, and financial viability. It also tries to maintain a representative weighting of industries. Because it represents about 75% of the total market, the S&P 500 is considered a broader representation of the U.S. equity markets than the Dow Jones Industrial Average.

Dow Jones Industrial Average (DJIA)
The DJIA, also called simply the Dow, is a price-weighted average of 30 well-known, actively traded stocks such as AT&T, Boeing, Coca-Cola, Exxon, General Motors, IBM, and McDonald’s. Though the Dow is the oldest and best-known stock index, it represents less than 25% of the market value of all stocks on the New York Stock Exchange. In addition to serving as a proxy for the performance of blue-chip industrial stocks, it has given rise to several investing strategies based on Dow stocks.

Nasdaq Composite Index
The Nasdaq index includes all 3,000-plus foreign and domestic stocks traded on the Nasdaq system, an electronic network of securities dealers. The market value-weighted index includes many high-tech companies whose stocks first began trading after the Nasdaq system was launched in 1971.

Wilshire 5000 Equity Index
The Wilshire 5000 includes not only common stocks but also real estate investment trusts (REITs) and master limited partnerships. Because almost all actively traded U.S. securities are included in it, it is considered the broadest U.S. equity index. However, because it is weighted by market capitalization, the Wilshire’s largest stocks account for the bulk of its total market cap and greatly affect its performance.

Russell 2000 Index
The Russell 2000 is a market cap-weighted index of approximately 2,000 stocks with market caps of less than $3 billion. It includes the smallest stocks represented in the Russell 3000 Index, another large domestic-stock index, and is often used as a benchmark for small-cap stocks.

MSCI EAFE Index
The EAFE (short for Europe/Australia/Far East), a market cap-weighted index of stocks in non-U.S. countries,focuses on stocks in large industrialized nations. It tends to be less volatile than indexes such as the S&P/IFCI, which focuses on securities in developing countries.

Watch Your Weight
Remember, indexes are generally either price weighted or market cap weighted. With a price weighted index, the highest-priced stocks have the most impact. By contrast, an index based upon market capitalization reflects the relative size of each company. Stocks with a larger market cap have more influence than smaller companies.

Investment Strategies: Learning from History’s Best

For golfers looking to improve their game, it can be useful to watch Tiger Woods. In the same way, investors can learn from the market’s great money masters. Though you may not have their experience or resources, you can study the philosophies they used to develop your own investing approach.

Think like an owner, not like a renter
This philosophy is as commonsense as the investor who is famous for following it: Warren Buffett. Any list of successful investors includes the chairman of Berkshire Hathaway, and he’s typically at the top of the list. The “Oracle of Omaha” is well-known for his down-to-earth approach to sizing up investments.

Buffett invests in businesses, not stocks, and prefers those with consistent earning power and little or no debt. He also looks at whether a company has an outstanding management team. Buffett attaches little importance to the market’s day-to-day fluctuations; he has been quoted as saying that he wouldn’t care if the market shut down completely for several years. However, he does pay attention to what he pays for a stock; as a value investor, he may watch a company for years before deciding to buy. And when he buys, he plans to hang on to his investment for a long time.

Don’t forget that markets can be irrational
Like Buffett, George Soros feels markets can be irrational. However, rather than dismissing their ups and downs, the founder of the legendary Quantum Fund made his reputation by exploiting macroeconomic movements. He once made more than $1 billion overnight when his hedge fund speculated on the devaluation of the British pound (he no longer actively manages the fund).

Soros believes in capitalizing on investing bubbles that occur when investors feed off one another’s emotions. He is known for making big bets on global investments, attempting to profit from both upward and downward market movements. Such a strategy can be tricky for an individual investor to follow. However, even a buy-and-hold investor should remember that market events may have as much to do with investor psychology as with fundamentals. Whether or not you apply Soros’s philosophy in the same way he does, that can be a valuable lesson to remember.

Use what you know; know what you buy
During his 13-year tenure at Fidelity Investments’ Magellan Fund, Peter Lynch was one of the most successful mutual fund portfolio managers in history. He subsequently wrote two best-selling books for individual investors.

If you want to follow Lynch’s approach, stay on the alert for investing ideas drawn from your own experiences. His “buy what you know” mantra asks you to examine your job, acquaintances, shopping habits, hobbies, and geographic location. Because of your in-depth understanding of these close-to-home subjects, you may be able to spot emerging companies before they attract attention from Wall Street. However, simply identifying a company you feel has great potential is only the first step. As with the other great investors, Lynch did thorough research into a company’s fundamentals to decide whether it was a good investment.

Lynch is a believer in finding unknown companies with the potential to become what he called “ten-baggers” (companies that grow to 10 times their original price), preferably businesses that are fairly easy to understand.

Make sure the reward is worth the risk
Perhaps the best-known bond fund manager in the country, PIMCO’s Bill Gross makes sure that if he takes greater risk–for example, by buying longer-term or emerging-market bonds–the return he expects is high enough to justify that additional risk. If it isn’t, he says, stick with lower returns from a more reliable investment. Because bonds have historically returned less than stocks and therefore suffer more from high inflation, he also focuses on maximizing real return (an investment’s return after inflation is taken into account).

Choose a sound strategy and stick to it
Even though all these investors seem to have different approaches, in practice they’re more similar than they might appear. Each of their investing decisions has specific, well-thought-out reasons behind it. They rely on their own strategic thinking rather than blindly following market trends. And they understand their chosen investing disciplines well enough to apply them through good times and bad.

You Are Not Alone
By working with a qualified financial advisor, you can find the strategy that matches your financial goals, time horizon, risk tolerance, and investing style.

Lifecycle Funds: Cruise Control for Your Investing Strategy

A central investing principle states that your portfolio’s asset allocation should depend upon your time horizon, which is the length of time remaining until you will need to cash in your portfolio’s assets. But how exactly you distribute your money between stocks, bonds, and cash? And how do risk tolerance and time frame affect your portfolio over time? And what if you want to totally avoid the hassle of ongoing rebalancing for your individual stocks, bonds, and mutual funds?

Set It and Forget It
A lifecycle fund–sometimes called a target fund–attempts to tailor your investing strategy to your time frame for a particular goal, such as retirement.

Let’s say you plan to retire in 2040. You might choose a fund with a target maturity date of 2040. Between now and then, the fund will gradually shift its asset allocation between stocks, bonds, and cash. The closer the target date, the more conservatively (less stocks, more bonds) the fund would invest. A lifecycle fund with a target maturity date of 2040 would be likely to have a higher percentage of its assets in stocks than a fund targeted at 2010.

Advantages of Lifecycle Funds
Asset allocation is critical to your long-term returns, but if the idea of regularly rebalancing your retirement portfolio prompts an anxiety attack, then a lifecycle fund can help you simplify the process. The automatic asset allocation of a lifecycle fund may give you a better chance of achieving a long-term goal than if you tried to go it alone without investing experience or good financial advice. (Note: Diversification alone does not guarantee a profit or insure against a loss.)

Disadvantages of Lifecycle Funds
If you have other investments outside of the lifecycle fund, you may need help from a financial professional to achieve an appropriate overall asset allocation for your portfolio. Additionally, a lifecycle fund does not consider your individual financial situation, including tax concerns.

Don’t Be Fooled By Look-Alikes
Just because a lifecycle fund targets a particular time frame doesn’t mean your choice is a slam dunk. Even if they have the same target maturity date, lifecycle funds from various companies may have different approaches to achieving their goals. Most take a “fund of funds” approach, investing in an assortment of stock or bond funds from the same fund family. However, the number of funds used can vary widely.

An aggressive allocation for one portfolio with a 2040 target date may have a significantly greater percentage of stocks than another. Another important difference among funds is the way asset allocations are shifted over time, particularly after the target date has been reached. Some reach their most conservative allocation at the target date and then keep those percentages static. Others continue to become more conservative after the target date is reached.

You Can Do It!
With lifecycle funds, it’s particularly important to take a long-term perspective. You do not want to jump in and out of the fund in response to daily market changes. Lifecycle funds’ objectives are long-term, and your short-term selling typically undercuts the overall strategy.

Check your assumptions
Just because a lifecycle fund has a certain target date doesn’t mean it’s necessarily the right choice for you. People are living longer, and you may need a more aggressive allocation to provide a sufficient nest egg. A qualified financial professional can help you estimate your needs and gauge what strategy is most likely to work best for you.

Stock market at record highs: Should you invest now?

Open the newspaper or turn on the TV, and you’re bound to see a recurring stock market theme: DOW SETS NEW RECORD! S&P AT ALL-TIME HIGH! So you ask yourself, “What the heck is going on?” Here’s the scoop…analysts, commentators, and equity investors are beside themselves with euphoria as the U.S. stock market continues its climb to uncharted altitudes, and this market is creating a lot of wealth for those who are along for the ride.

Keep it in Context
Even though the U.S. stock market is rising to record levels, these statistics are not the end-all-be-all measures of our nation’s financial status. Let’s not forget the other (currently less favorable) economic indicators and their effects on our economy:

• Consumers are saddled with enormous levels of revolving debt
• Real wage growth is stagnant
• Personal savings rates are at 70-year lows
• Home-foreclosure rates are accelerating
• Gasoline prices are at 25-year highs
• Our nation is bogged down in a costly, unpopular war
• Health care & college tuition costs are easily outpacing inflation

This all adds up to a perfect storm of reduced consumer spending. In other words, the amount of disposable income the average American has available to spend on products and services is quickly declining beyond expectations…just ask Wal-Mart and Gap Inc.

Some might dismiss these consumer statistics as insignificant, particularly since corporate profits remain strong. But let’s not forget that consumer spending accounts for two-thirds of our nation’s Gross Domestic Product (or GDP). GDP is one of the ways we measure the size of the U.S. economy. So when consumer spending slows, guess what? You got it…the U.S. economy contracts. This contraction is an indicator of negative economic growth, also known as recession.

Now before you go running outside to see if the sky is falling, please note that we are not predicting a massive downturn in U.S. stock market stability. We are, however, suggesting that the national economic picture may not be as rosy as pundits, commentators, and Wall Street experts would have you to believe.

Stay Focused…and Cautious
As investing sage Warren Buffett once said: “Be fearful when others are greedy and greedy when others are fearful.” With investors now seeing dollars signs everywhere, market greed is spreading like wildfire. Buffett’s wise words urge you to remain prudent and to go forward with your eyes wide open, particularly as the ever-hungry market mavens continue to beat the drums of higher…higher…higher.

Where Does the Market Typically Go After a New High?
Mark Arbeter, Chief Technical Strategist at Standard & Poor’s chimes in on this point:

“If history can serve as a guide…we will likely see sub-par price performance in the first month following the setting of a new high, and then find above-average price appreciation in the three and six months after. In addition, the next market top usually occurred around three years after the setting of a record high.“

Once again, do not take Mr. Arbeter’s words as the gospel. He may be right…he may be wrong. But nobody–and we mean nobody–knows at what levels our stock market will be one, three, or ten months from now…and if they did, trust us, they wouldn’t tell you or anybody else!

So What Do You Do Now?
Carry on business as if it’s just another day. Continue your regular contributions to a 401k plan. Continue buying shares of an index mutual fund within your Roth IRA. Continue practicing intelligent spending habits.

There is no reason to lose your head and begin taking unnecessary risk when you’ve already developed a plan to succeed. Be patient, and be smart.

Investing: Key Terms and Concepts

Below are summaries of some basic principles you should understand when evaluating an investment opportunity or making an investment decision. Rest assured, this is not rocket science. In fact, you’ll see that the most important principle on which to base your investment education is simply good common sense.You’ve decided to start investing. If you’ve had little or no experience, you’re probably apprehensive about how to begin. Even after you’ve found a trusted financial advisor, it’s wise to educate yourself, so you can evaluate his or her advice and ask good questions. The better you understand the advice you get, the more comfortable you will be with the course you’ve chosen.

Don’t be intimidated by jargon
Don’t worry if you can’t understand the experts in the financial media right away. Much of what they say is jargon that is actually less complicated than it sounds. You’ll learn it soon enough, and there is no reason to wait to invest until you know everything.

IRAs hold investments–they aren’t investments themselves
One of the most common questions we answer is rooted in a key source of confusion that throws many new investors off: If you have an individual retirement account (IRA), a 401(k), or any other retirement plan, you should recognize the distinction between that account or plan itself and the actual investments you own within that account or plan. Your IRA or 401(k) is just a tax-advantaged container that holds your investments. Many consumers are often become confused when this distinction is not emphasized (i.e. You cannot buy $1000 worth of an IRA; you can buy $1000 worth of a mutual fund that you hold within an IRA).

Understand stocks, mutual funds, and bonds
Almost every portfolio contains these kinds of assets.

If you buy stock (or a stock mutual fund), you are literally buying pieces of companies from an existing owner who wants to sell. You become an owner, or shareholder, of the company. As such, you take a stake in the company’s future. If the company prospers, there’s no limit to how much your share can increase in value. If the company fails, you can lose every dollar of your investment.

If you buy bonds, you’re lending money to the company (or governmental body) that issued the bonds. You become a creditor, not an owner, of the bond issuer. The bond is your IOU. As a lender, your return is limited to the interest rate and terms under which the bond was issued. You can still lose the amount of the loan (your investment) if the company or governmental body fails, but the risk of loss to creditors (bondholders) is generally less than the risk for owners (shareholders). This is because, to stay in business, a company must maintain as good a credit rating as possible, so creditors will usually pay on time if there is any way at all to do so. In addition, the law favors bondholders over shareholders in the event of bankruptcy.

FYI — Stocks (and stock mutual funds) are referred to as “equity investments”, while bonds (and mutual funds containing bonds) are often called “investments in debt”.

Diversify–don’t put all your eggs in one basket
This is the most important of all investment principles, as well as the most familiar and sensible.

Consider using several different classes of investments for your portfolio. Examples of investment classes include stocks, bonds, mutual funds, art, and precious metals. Investment classes often rise and fall at different rates and times. Ideally, in a diversified portfolio of investments, if some are losing value during a particular period, others will be gaining value at the same time. The gainers help offset the losers, and the total risk of loss is minimized. The goal is to find the right balance of different assets for your portfolio. This process is called asset allocation.

Recognize the trade-off between the risk and return of an investment
For present purposes, we define risk as the possibility of losing your money, or that your investments will produce lower returns than expected. Return, of course, is your reward for making the investment. Return can be measured by an increase in the value of your initial investment principal and/or by cash payments directly to you during the life of the investment. There is a direct relationship between investment risk and return.

Between the extremes, every investor aims to find a level of risk–and corresponding expected return–that he or she feels comfortable with.

Investing for growth vs. Investing for income
As an investor, you face an immediate choice: Do you want growth in the value of your original investment over time, or is your goal to produce predictable, spendable current income–or a little of both?

There is no right or wrong answer to the “growth or income” question. Your decision should depend on your individual circumstances and needs (e.g., your need, if any, for income today, or your need to accumulate a college fund, not to be tapped for 15 years).

The power of compounding
A simple example of compounding occurs with a bank certificate of deposit that is allowed to roll over each time it matures. Interest earned in one period becomes part of the investment itself, earning interest in subsequent periods. In the early years of an investment, the benefit of compounding on overall return is not exciting. As the years go by, however, a “rolling snowball” effect seems to operate, and the compounding’s long-term boost to investment return becomes dramatic.

Six Secrets to Successful Investing

A successful investor maximizes gain and minimizes loss. Here are six basic principles that may help you invest successfully.

Long-Term Compounding
It’s the “rolling snowball” effect. Put simply, compounding pays you earnings on your reinvested earnings. The longer you leave your money at work for you, the more exciting the numbers get. For example, imagine an investment of $10,000 at an annual rate of return of 8 percent. In 20 years, assuming no withdrawals, your $10,000 investment would grow to $46,610. In 25 years, it would grow to $68,485, a 47 percent gain over the 20-year figure. After 30 years, your account would total $100,627. (Of course, this is a hypothetical example that does not reflect the performance of any specific investment.)

This simple example also assumes that no taxes are paid along the way, so all money stays invested. That would be the case in a tax-deferred individual retirement account or qualified retirement plan, or even if you just bought and held shares of a stock that paid no dividends. The compounded earnings of deferred tax dollars are the main reason experts recommend fully funding all tax-advantaged retirement accounts and plans available to you.

While you should review your portfolio on a regular basis, the point is that money left alone in an investment offers the potential of a significant return over time. With time on your side, you don’t have to go for investment “home runs” in order to be successful.

Ride Out Market Volatility
It sounds simple, doesn’t it? But what if you’ve invested $10,000 in the stock market and the price of the stock drops like a stone one day? On paper, you’ve lost a bundle, offsetting the value of compounding you’re trying to achieve. It’s tough to stand pat.

There’s no denying it–the financial marketplace can be volatile. Still, it’s important to remember two things. First, the longer you stay with a diversified portfolio of investments, the more likely you are to reduce your risk and improve your opportunities for gain.

Second, during any given period of market or economic turmoil, some asset categories and some individual investments historically have been less volatile than others. Bond price swings, for example, have generally been less volatile than stock prices. Although past performance cannot predict future results, you can minimize your risk somewhat by diversifying your holdings among different classes of assets, as well as different individual assets within each class.

Asset Allocation: Spread the Wealth
Asset allocation is the process by which you spread your investment dollars over several categories of assets, usually referred to as asset classes. These classes include stocks, bonds, cash (and equivalents), real estate, precious metals, collectibles, and insurance products.

For many average investors, the focus is almost entirely on stocks, bonds (or mutual funds of stocks and bonds), and cash. You’ll therefore also see the term asset classes used to refer to subcategories of these investments, such as aggressive growth stocks, long-term growth stocks, international stocks, government bonds (U.S., state, and local), high-quality corporate bonds, low-quality corporate bonds, and tax-free municipal bonds.

There are two main reasons why asset allocation is important. First, the mix of asset classes you own is a large factor–some say the biggest by far–in determining your overall investment portfolio performance. In other words, the basic decision to divide your money 80 percent in stocks and 20 percent in bonds is probably more important than your subsequent decisions over exactly which companies to invest in, for example.

Second, by dividing your investment dollars among asset classes that do not respond to the same market forces in the same way at the same time, you can minimize the effects of market volatility while maximizing your chances of return in the long term. Ideally, if your investments in one class are performing poorly, you will have assets in another class doing well. The gains in the latter will offset the losses in the former, minimizing the overall effect on your portfolio.

Consider Liquidity in Your Investment Choices
Liquidity refers to how quickly you can convert an investment into cash without loss of principal. Generally speaking, the sooner you’ll need your money, the wiser it is to keep it in investments with comparatively less volatile price movements. You want to avoid a situation, for example, where you need to write a tuition check next Tuesday, but the money is tied up in a long-term mutual fund whose price is currently experiencing a loss.

Therefore, your liquidity needs should affect your investment choices. If you’ll need the money within the next one to three years, you may want to invest in short-term bonds, certificates of deposit, a money market account, or a savings account. Your rate of return will likely be lower than that possible with more volatile investments such as stocks, but you’ll breathe easier knowing that the principal you invested is relatively safe and quickly available, without concern over market conditions on a given day.

Dollar Cost Average for Consistency
Dollar cost averaging is a method of accumulating shares of stock or a mutual fund by purchasing a fixed dollar amount of these securities at regularly scheduled intervals over an extended time. When the price is high, your fixed-dollar investment buys less, but when the prices are low, the same dollar investment will buy more shares. A regular, fixed-dollar investment should result in a lower average price per share than you would get buying a fixed number of shares at each investment interval.

Remember that, just as with any investment strategy, dollar cost averaging can’t guarantee you a profit or protect you against a loss if the market is declining. To maximize the potential effects of dollar cost averaging, you should also assess your ability to keep investing even when the market is down.

An alternative to dollar cost averaging would be trying to “time the market,” in an effort to predict how the price of the shares will fluctuate in the months ahead so you can make your full investment at the absolute lowest point. However, market timing is generally unprofitable guesswork. The discipline of regular saving is a much more beneficial strategy, and it takes no mental effort or study.

Buy and Hold…Don’t Buy and Forget
Unless you plan to rely on luck, your portfolio’s long-term success will depend on periodically reviewing it. Maybe your uncle’s hot stock tip has frozen over. Maybe economic conditions have changed the prospects for a particular–or a whole class of–investment.

Even if nothing bad at all happens, your investments will appreciate at differing rates, so after a while, your asset allocation mix will change. For example, if you initially decided on an 80 percent to 20 percent mix of stocks to bonds, you might find that the total value of your portfolio has become divided 88 percent to 12 percent. When that’s the case, you’ll need to rebalance your portfolio.

Rebalancing involves restoring your original asset allocation decisions by shifting your funds among investment classes to restore the ratios you decided on in first designing your portfolio. Many investment advisors recommend using shifts of 5 percent or more as a trigger for rebalancing. Others recommend doing it every year.

Hello World!

As Lightship Mutual joins the ranks of the online blogosphere, we look forward to providing insightful wit and biting commentary into today’s social, political, and technological events as they relate to your personal finances.

Mission: Blog
The Daily Compass represents the ongoing thoughts, musings, and opinions of the advisors of Lightship Mutual. This forum serves to compliment our monthly newsletter, ‘The Lightship Compass’. If you are not yet on our email list, click here to begin receiving our monthly publication, as well.

Staying true to our overall company’s mission, we believe that this forum belongs to you. We fully anticipate a heavy involvement from our site visitors, and we look forward to providing accurate, clear, fast responses to your questions and comments.

Here Comes the Neighborhood
As the new kids on the blogosphere block, we’re happy to be a part of your community. We promise: a well-manicured lawn, no loud music, and we’ll only decorate the backside of our house with pink and green shutters. So feel free to drop by anytime with some fruit cake, punch, or any other treats from the welcome wagon. There are always interesting conversations around here, and we are truly excited to be a part of your online experience.

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