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Index Investing

Vladimir Daragan, STTA Consulting Inc.

You probably know that about 80% of mutual funds perform worse than SP 500. This is why the index funds are so popular. The other solution is buying Index Shares which are trading on AMEX. We will consider two popular index shares:

DIA - based on the Dow Jones industrial Average

and

QQQ - based on the NASDAQ 100 index.

Historically the return of QQQ is larger but the volatility (risk) of this index is much higher than the volatility of DIA. How to take advantage of high return of QQQ and reduce risk of investing? We will try to answer this question of this page

Consider the average monthly returns for these indices. The results for the 1985 - 2001 period are shown in the Table.

Index	Average Monthly Return	Risk	Risk/Return Ratio
Dow Jones Industr. Average	1.22 %	4.53	3.72
NASDAQ 100	1.84 %	7.78	4.24

Risk is defined as a standard deviation of the monthly returns for this period. (Click here to find out more about risk and returns.)

The solution of this problem is finding the optimal fraction c (%) of the investing capital to invest in Dow Jones index shares. We mentioned many times that optimal distribution of the investing (trading) capital corresponds to minimal risk/return ratio (click here for details). The next plot shows the dependences of the average monthly returns and risk on the fraction c.

retris.gif (4015 bytes)

One can see that risk becomes smaller if one increases the fraction of the capital invested in the Dow Jones. However, the return is also smaller. To find the optimal c we plot the dependence of the risk/return ratio on the fraction c.

rr.gif (3671 bytes)

One can see that risk/return ratio is minimal if c = 0.75. However, taking into account that dividends of Dow Jones stocks are higher than stocks from NASDAQ 100 the optimal c is about 70%.

Therefore, one can conclude that the optimal distribution of the investing capital is:

75% in Dow Jones
25% in NASDAQ 100

The average (expected) monthly return is approximately equal to 1.4% and the risk/return ratio is about 3.6.

Disclaimer: We provide these data only for information and for educational purposes. Do your own research before making any trading or investing decision.