Investment Bench Mark

Investment Bench Mark

Investment Bench Mark

A better bench mark for evaluating the skill of individual investorsin picking stocks would be a combination index of stocks listed onthe New York Stock Exchange and American Stock Exchange. Astill better index would include the over-the-counter stocks. A stillbetter one would include bonds and other things. Unfortunately, theofficial index of the American Stock Exchange is not a value-weightedindex, and the index of the over-the-counter stocks is not inclusiveor necessarily representative.

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Someone would do the financial community a great service by constructing a value-weighted index that included stocks not on the New York Stock Exchange. In the meantime, investors seeking a bench mark can probably struggle along withoutmajor error by using one of the value-weighted indexes for the NewYork Stock Exchange.

An argument can be made for using an index in which each stockreceives equal weight. In computing the tables of rates of return oncommon stocks listed on the New York Stock Exchange, Fisher and Lorie gave equal weight to each stock. Such an indexprovides perhaps the simplest nai've model with which to comparethe performance of actual portfolios of common stocks. It is the modelwhich corresponds to the dramatic and implausible picture of a manpicking stocks by throwing darts or by some more rigorous randomprocess. An index based upon equal weighting shows the results ofan investment policy based on random selection with equal probabilities of selecting each stock; the value-weighted indexes correspondto an investment policy based on random selection with probabilitiesof selection proportional to market value.f

It is impossible to state categorically which kind of index provides the best bench mark, but it is worth noting that the choice can havepractical consequences. The study of mutual fund performance.

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Friendet al shows that their sample of 136 mutual funds on the aver age had an annual rate of return compounded monthly of 10.7 percentfor the period January 1960 through June 1968. This was inferiorto the annual rate of 12.4 percent based on portfolios of stocks withequal weights and was superior to the annual rate of 9.9 percent basedon indexes of stocks with weights proportional to market value.2 Themargins of inferiority and superiority were probably not so great asto justify a confident conclusion that managers of mutual funds pickedstocks better or worse than a random process with either equal probabilities of selection or probabilities proportional to market value. Mostobservers would probably conclude that mutual funds demonstratedneither superiority nor inferiority during the period under study.Nevertheless, it is worth keeping in mind that the choice of indexcan make a difference and that occasionally it might even beimportant.

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