You see this on the nightly news. It is discussed among “grown ups.” People toss these phrases around sounding sophisticated. But what does the S&P or the DOW really mean? Why does it matter? And how does it affect you?
To start, let’s define these two: the S&P 500, often referred to simply as the S&P, is a market index listing 500 U.S. publicly traded companies. The Dow Jones Industrial Average, commonly referred to as the DOW, is a market index listing 30 of the largest U.S. publicly traded companies.
These are oversimplified definitions so let’s dig a little deeper. First called the “Composite Index” in 1923, the name changed to the S&P 500 in 1957. This is a market capitalization weighted index where the index includes the total public market value of a company in its formula. In the S&P, the larger companies gain the largest percentage of the index. The result is that the S&P is considered a good gauge of large U.S. equities, though small and mid-sized companies are present in the index. The DOW, designed in 1896 to serve as a proxy for the broader U.S. economy, began as a purely industrial index. It is possibly the single most watched index in the world and is the second oldest U.S. index behind the Dow Jones Transportation Average. The DOW is a price weighted index; the prices of the 30 stocks in the DOW are added together then divided by the DOW divisor, resulting in the number that you see stated daily.
Why does this matter? These two indices are highly publicized in the financial news. Many people see these gauges as benchmarks for the overall stock market. Yet, there is a problem in their methodology. The S&P is hyper sensitive to the price movement of its largest companies. For example, in October 2018 Seeking Alpha reported that the top 5 contributors to the S&P 500 resulted in 42.4% of the index’s gain for the year. In other words, 1% of the stocks in the index drove 42% of the return. If 5 stocks can drive this much of the index gain (or loss) this results in a very poor benchmark for the total U.S. stock market. The DOW has even worse measurables.
Why does this really matter and how does this affect you?
When you ask “How did the market do today,” what answer do you expect? If you hear that the S&P went up 1%, do you think “great, I made money.” Or if the S&P lost big, do you drop your head thinking “ugh, here we go again?” Yet, have you ever asked your advisor, “what is my portfolio’s proper benchmark?” or “What should I compare my results to?” This question is very important. We want you to have proper expectations for your returns and neither the S&P nor the DOW set proper expectations. In our opinion both are poor indices to invest in and both are poor benchmarks though they make for great talking points on news shows.
Please contact us with any questions and feel free to ask your Sound Financial advisor how your model compares to these and what your model’s benchmark should be.