If you’ve ever heard someone say “how did the market do today,” chances are they are referring to the Dow Jones Industrial Average (“Dow”), one of the oldest indexes used in the U.S. Indexes such as the Dow are used to measure the general health of a segment of the economy. Indexes are not just used in the U.S., they are also used in nearly every country with a developed financial market. Some of the most well known indexes include: Financial Times Stock Index (U.K.), CAC 40 (France); Hang Seng (Hong Kong); All Ordinaries (Australia); and many more. Indexes are also used as benchmarks for investors and asset managers to evaluate their performance. But while indexes have become widely used and followed throughout the world to measure and compare financial performance, their composition and calculation do not always represent the markets they intend to capture.
The most widely used and most closely watched index around the world is the Dow. The Dow is a price weighted index representing 30 U.S. companies that trade on the New York Stock Exchange. As a price weighted index, the Dow is heavily influenced by the stock with the highest price. For example, IBM the highest priced stock in the Dow at over $140 per share has a greater influence on the Dow than Bank of America, the lowest priced stock trading below $15 per share. Hence a $3 change in price of IBM has a greater impact on the price of the Dow than a $3 change in Bank of America, even though the $3 change in Bank of America would represent a nearly 20 percent change in its price! In addition, with well over 8,000 stocks listed on the New York Stock Exchange (source: www.nyse.com), not including those trading on other U.S. exchanges, the Dow represents only a small fraction of the total U.S. market, and thus cannot possibly reflect the health of the entire U.S. financial market. For this reason, the Dow is seldom, if ever, used as a benchmark, but its psychological influence on investors is immense.
In recent years, the Standard and Poor’s 500 Index (“S&P 500”) has become more widely quoted in the media to gauge the health of the U.S. financial markets. In addition, the S&P 500 is also commonly used as a benchmark for many fund managers and investors to evaluate their performance. But it too has its faults. The S&P 500 is a value weighted index comprised of the top 500 publicly traded stocks in the U.S. As a value weighted index, the S&P 500 is not influenced by stocks with the highest price, as is the case with the Dow; however, the S&P 500 is heavily influenced by the largest companies as measured by their market values. The market value of a company is the value of all the shares outstanding or the total price someone would pay to buy up all the shares of a company. For example, as of September 30, 2010 (source: www.standardandpoors.com), the companies that had the biggest impact on the S&P 500 index because of their market values were Exxon Mobil, Apple Computer, and Microsoft. As you can imagine, the weight of these companies can cause the returns of the S&P 500 to closely match the returns of the largest companies. For this reason, as certain sectors become more popular, such as the financials before 2008, and their market values increase, they begin to represent a greater share of the S&P 500 index. Lastly, because the index is value weighted, it tends to be biased towards large, more mature, and maybe overvalued companies. Nevertheless, most investors and portfolio mangers compare themselves against the S&P 500.
Indexes represent an important leading economic indicator, and contribute to the investment decision making process because they help investors quickly assess the overall performance of a given market segment and measure their performance against an index. For example, most bond investors compare their performance to the Barclays Aggregate Bond Index (formally known as the Lehman Brothers Aggregate Bond Index); investors in smaller companies compare their performance to the Russell 2000 index; and most international investors compare their performance with the MSCI EAFE index. Despite their limitations, the Dow and the S&P 500 still dominate the index universe and are the most widely followed and influential indexes. Their performance, regardless of how few companies influence their calculations, reverberates around the world. No index construction method is perfect; price weighted is influenced by the highest priced stock, value weighted by the largest companies, and an equal weighted index is biased toward smaller companies, but it is important for investors to recognize such limitations and appropriately evaluate performance.
*Talk with your Fee-Only financial advisor before making investment decisions.