Whenever people refer to the “market,” I’m reminded of the line from “The Princess Bride”: “You keep using that word. I do not think it means what you think it means.”
It’s not just a question of semantics. An overly narrow view of what constitutes the market could lead to less than optimal investing and portfolio management.
What most people mean by the market is the Dow Jones industrial average, or just “the Dow.” It’s the index most commonly cited when describing stock market movements. The market report on the nightly news or in the business section of your local paper probably also follows two other major indexes: the Standard & Poor’s 500 index and the Nasdaq composite. But when you hear that the market crashed 611 points on Brexit news, analysts are talking about the Dow.
The Dow’s importance is understandable when you consider that it’s the oldest major stock market index, dating back to the mid-1880s. At that time, it tracked only 12 stocks. It began tracking 30 in the 1920s, the same number it tracks today.
That might have been adequate almost 100 years ago, but in 2015 there were more than 4,000 publicly traded companies in the U.S. and more than 40,000 worldwide. So following the Dow in isolation might give you a view of stock performance that’s inconsistent with the broader reality.
The Dow vs. other markets
Oct. 26, 2016, seemed to be an uneventful trading day. The Dow closed with a gain of 30.06 points, or 0.17%. Not a big day, but still positive. What does this tell you about stock performance that day? You’d probably assume that it was mixed: some up, some down. Probably a bit more up than down, right?
You’d be wrong. Nearly twice as many stocks fell as rose that day, according to data from Yahoo Finance. The S&P 500 lost 0.17%, while the Nasdaq closed down 0.63%. Broader U.S. stock market indexes, such as the S&P 1500 composite, the Dow Jones Total Stock Market and the Russell 3000 all lost: 0.22%, 0.26% and 0.26%, respectively. It appears the Dow was alone in posting gains.
Perhaps the difference is that the companies in the Dow are major multinational firms, so their stock prices act more like those of global stocks? The problem here is that stocks in virtually every major country were also down that day. The British FTSE, German DAX and China’s Hang Seng were all negative. Only Japan’s Nikkei eked out a small gain of 0.15%.
Almost any way you look at it, stocks were down on Oct. 26. But there it is: +30.06 points.
The problem with the Dow
The Dow is the only major index that is price-weighted. This means that the higher the underlying stock’s price, the more it influences the movement of the Dow.
For example, Goldman Sachs, which is trading at around $178 per share, counts for around 6.7% of the movement of the Dow. However, its market capitalization — the value placed on it by public-market investors — is $73 billion, meaning it makes up only 1.3% of the collective market cap of the 30 companies.
Microsoft, on the other hand, is trading at around $60 per share. It accounts for only 2.3% of the Dow’s index price but more than 8.6% of the market cap, with a value of more than $470 billion.
Microsoft’s market cap is more than six times larger than Goldman’s, yet a dollar change in Goldman’s stock price moves the Dow nearly three times as much as an equivalent move in Microsoft’s stock price.
A company’s market cap is a much better way to weight the components of an index. The companies with the largest market cap typically have a greater influence on the movement of stocks across multiple indexes. On top of that, stock splits and other nonmarket-driven factors can render the actual price somewhat arbitrary.
How investors should respond
Admittedly, there’s no perfect index. The widely quoted S&P 500 is focused only on the largest U.S. companies, neglecting the majority, along with the rest of the world. The Nasdaq overrepresents technology companies.
That’s why you can’t measure your portfolio based on any one index. If you want to do so, compose a benchmark comparison that’s representative of your target allocation, including a large cap U.S. index, a small cap index and an international index; a bond index for your bonds; and an index for any additional asset classes that you hold in your portfolio. And like your portfolio, don’t leave the benchmark to drift out of balance. Rebalance periodically to ensure a fair representation of your portfolio’s performance relative to the benchmark.
That’s more of an endeavor than most people want to take on. Before designing your benchmarks, ask yourself if this is important to you.
Instead of comparing your portfolio to an arbitrary index or composite of indexes that has nothing to do with your life and goals for your family, focus on your sound, long-term financial plan. This means defining your goals, knowing how much you should be saving to get there and understanding how much risk is appropriate for you.
This article was first published on Nerdwallet.com