Undoubtedly, as you listen to the radio or watch your favorite news channel, you have heard some reference to the Dow Jones being up or down for the day. On a general level you know that when the Dow is “up” the stock market is doing well and when the Dow is “down”, the stock market is down.
The Dow Jones Industrial Average (often called the Dow or the Dow Jones) was launched in 1896 as a stock market indicator. It is a price-weighted index of 30 U.S. blue-chip companies. That’s right, only 30 companies. And they are companies you’ve most likely heard of like Apple, Disney, and Coca-Cola. Most of us hear how the Dow is doing and either feel good or bad about our investment portfolios. Is it realistic to measure our personal portfolio performance against only 30 companies especially when a diversified portfolio full of mutual funds could hold hundreds or thousands of companies?
Maybe the solution is to use a bigger index. How about the S&P 500, an index (started in 1957) that measures the performance of 500 large U.S. companies including giants like Apple, Amazon, and Exxon? Certainly, 500 companies might better represent our portfolios. So yes, the S&P 500 is a good measure of how our portfolios are doing. Well, at least the U.S. large cap equity portion. When you consider that more than 2,400 companies trade on the New York Stock Exchange, and another 3,200 trade on Nasdaq, maybe 500 companies still isn’t a true measure of our portfolio performance. And we still haven’t counted the thousands of companies that trade on other exchanges.
We preach the importance of having a diversified portfolio to minimize volatility and a diversified portfolio should be just that – diversified. This means owning the stock of blue-chip companies and large cap companies. It also means holding the stock of small companies and mid-sized companies. It includes the stock of growth companies and value companies, international and domestic companies. In addition, a diversified portfolio will probably hold bonds, and maybe real estate, energy, metals and other sectors of the economy. A diversified portfolio holds a little bit of a lot of asset classes.
A market index is a metric that tracks the value of a group of investments. If an index goes up, the group of investments that it is tracking has, correspondingly, also gone up. While the Dow Jones and S&P 500 are important to stock market indices, they only measure the performance of U.S. large companies, and a limited number at that. The same company that manages these indices also has market indices for specific asset classes and specific segments of asset classes. They even offer indices for investment strategies. Basically, there is a market index for almost every type of investment. That’s good news because these indices provide essential intelligence about certain markets and allow us to track how your investments are doing in their specific markets. Market indices help us understand what we can expect from these investments and help us make decisions with confidence.
If market indices are so important, you may ask, “Why not just invest in the market indices?” The answer is because we can’t. The market indices are not publicly traded. There are no shareholders of market indices. They are simply measures of market activity. For this reason, many investment companies have developed mutual funds that mimic the market indices so that you can get as close as possible to owning the market index.
Market indices are also referred to as benchmarks. Your 401(k) (or 403(b) or TSP) investment options often list the S&P 500 as a benchmark so you can see how your funds have done in relation to the S&P 500. Be careful not to jump to conclusions about all of the investment options available to you. Remember that the S&P 500 only measures large U.S. companies and is only a valid benchmark for investment options in large U.S. companies. Bonds should be compared to a bond index, small cap funds should be compared to a small cap index, and international funds should be compared to an international index.
Likewise, the next time you hear on the news that the Dow Jones has spiked or dropped, take a breath and realize that this only reflects the portion of your portfolio invested in U.S. blue-chip companies. The Dow and the S&P 500 are important indices to understand, they are not comprehensive measures of a diversified portfolio. And they are not comprehensive measures of your portfolio.