When it’s time for a physical checkup, most people go to a general practitioner. Although an ear, nose and throat specialist would have more expertise in those particular organs, it’s your entire body that you want to evaluate.
Why isn’t it the same with the stock market? If you tune in to any news channel or pick up any newspaper, the one U.S. stock market benchmark you will inevitably find reported is the Dow Jones industrial average. Yet the Dow is not very representative of the market, or even of industrial stocks. So why has this benchmark become so ubiquitous as a stock market performance measure?
The answer might be that the Dow is simply one old index. It was created by Dow Jones & Co. co-founder Charles Dow in 1896. That’s a pretty long-lived track record. The problem is that it’s hard to use the Dow to measure any kind of long-term performance for the following reasons.
• The 30 stocks listed on the Dow – which is not a very representative sample out of approximately 3,000 publicly traded U.S. companies – are chosen and updated periodically by a selection committee at S&P Dow Jones Indices. To my knowledge, the criteria by which they are selected are not publicly disclosed.
• The composition of the Dow is constantly changing. In fact, the original index comprised only 12 stocks. It wasn’t until 1928 that it grew to its current size.
• With different companies moving in and out of the index over time, the Dow lacks consistency. The only company that remains on the index since its inception is General Electric.
• As if that weren’t enough, there’s a bigger problem with the Dow, and that is how it’s calculated. It is a price-weighted average, which means the higher the stock price of a company in the index, the bigger the impact of its price movements on the overall index average.
Even a company stock split (which actually has no impact on the company’s valuation) would cause the Dow to fluctuate. I can think of no rational reason for this approach other than possibly the ease of calculation during all those earlier years when computers were not available.
The Standard & Poor’s 500 index, by contrast, is a market capitalization-weighted index. This means the weighting of each stock is based on its price times the number of shares outstanding, which is logically a better measure of value. And with 500 stocks in the index, it is certainly more representative of the broader market. Standard & Poor’s, which owns both indices, also uses objective criteria by which a company can join or exit this index.
Then there are indexes that cover the entire U.S. stock market, like the Russell 3000, which includes the 3,000 largest publicly held companies in the U.S. (representing approximately 98 percent of all U.S. public equity) and follows the same cap-weighted methodology as the S&P 500. Wouldn’t that be a better benchmark for the media to report?
Perhaps it really doesn’t matter. What’s much more important than how your investment portfolio compares to some benchmark is whether it is growing sufficiently to support what you want to do for the rest of your life.
My advice would be to eschew all such benchmarks and instead concentrate on the appropriate balance of investment risk and return needed to meet your future goals. You’ll discover how much less stressful your checkup visits with your doctor will become.