Gary ends his articles each week with the instruction to “be vigilant and stay alert.” I agree that it is critical for all of us to be attentive to not only our personal finances, but the financial world in general. How do we do that? Usually, we listen to the news. So, it is important to understand what the news is reporting on.
Most mainstream media reports on the three most familiar market indices: the S&P 500, the Dow and the Nasdaq. In fact, we seem to be hearing these reports more and more often as every day those same newscasters pontificate on the likelihood of the Dow reaching 20,000. (As I write this article, this has not happened yet.) And oftentimes, those same reporters make general statements such as “the markets are up” or “the markets are down.” So, you may question which of those indices, if any, truly reflect “the market”—the market that those same newscasters refer to in such broad strokes.
Now, I am going to get a bit technical here. Please stay with me and I will explain why this information should be important to you.
Generally, a market index tracks the movement in value of a group of stocks to get an idea of the general movement of the “market” that index represents. This movement is measured by comparing the aggregate value of a group of stocks in an index against the aggregate value of the same general group as of a specific date. Therefore, it is important to understand the type of stocks included in the various indices and how the values of those stocks are calculated.
So let’s talk about the three big ones that we always hear about, starting with the S&P 500. The S&P 500 tracks the performance of (you guessed it) 500 publicly traded large-cap companies. Those 500 companies are selected by the Standard & Poor’s Index Committee. Their selection is based on various factors including market size, liquidity and industry grouping. All of the companies in the S&P 500 must have a market capitalization of at least $5.3 billion and all are traded on either the New York Stock Exchange or the Nasdaq Stock Market. They represent all industries and all areas of the country, with only a small percentage being headquartered outside the United States. Therefore, the S&P 500 is considered a good representation of the overall large-cap US stock market.
The S&P 500 Index measures the movement of those companies by tracking their total market capitalization. First, each company’s market capitalization is determined by multiplying the number of outstanding shares by the company’s current share price. The total market capitalization of all of the 500 companies is aggregated, and then a divisor is applied to this total capitalization to make reporting of that number more manageable.
And this, Cutter Family Finance readers, is the final number that you see on the news every night. (The divisor is adjusted when corporate actions, such as the issuance of additional stock, would otherwise affect the relative value of a company in the index.) Then each company is weighted by comparing its market capitalization to the total market capitalization of the group. Any change in an underlying stock is reflected in the index in proportion to its weight in the index.
The Dow Jones Industrial Average, or “the Dow” is another well-known index, frequently referred to as a measure of the United States stock market. The Dow, however, comprises only 30 different large-cap companies, chosen by the editors of The Wall Street Journal. To be chosen for inclusion in the index, a stock must be a leader in its industry and must be widely held by both individual and institutional investors (i.e., pension plans, mutual funds, et cetera). But unlike the S&P 500, the Dow is a price-weighted market index, giving more weight to more expensive stocks. To calculate the Dow, the price of those 30 selected stocks are added together and then divided by the Dow divisor, which is modified when necessary to account for stock splits and stock dividends.
The last of the big ones is the Nasdaq Composite Index. This index tracks most of the companies that are traded on the Nasdaq Stock Market, more than 3,000 stocks of varying size, many of which are technology stocks and some of which are incorporated outside of the United States (unlike companies listed on the Dow). Both the index and the exchange are commonly referred to as the Nasdaq, which originally stood for the National Association of Securities Dealers Automated Quotations.
Like the S&P 500, the Nasdaq is a market capitalization weighted index and is calculated similarly. But as mentioned above, the index is heavily made up of technology stocks. In fact, as of May 31, 2016, technology stocks were weighted at 42.49 percent of the Nasdaq Composite Index. That is why, in part, the Nasdaq tends to be a bit more volatile than the Dow or the S&P 500.
Because each index tracks a different set of companies, they have different day-to-day results, some up and some down. However, as explained above, movement in the S&P 500 and the Dow, for the most part, represent movements in US large-cap stocks. The problem with looking at just those three indices is that there are many other “markets” and asset classes to be aware of, such as small-cap domestic stocks, mid-cap domestic stocks, international stocks, commodities and fixed income. An investment strategy that includes only large-cap domestic stocks, although on a run up recently, may carry too much risk for many investors.
The risk-return tradeoff is at the core of what asset allocation is all about. It’s easy for everyone to say that they want the highest possible return, but simply choosing assets with the highest “potential” return (stocks and derivatives) is not always the answer.
The crashes of 1929, 1981, 1987 and the more recent declines of 2001-2003 and 2007-2009 are all examples of times when investing in only stocks with the highest potential return would not have been the most prudent plan of action. But, unfortunately for many, they chased those returns and suffered the consequences.
It’s time to face the truth; every year one investor’s returns will be beaten by another investor, mutual fund, pension plan, et cetera. What separates greedy and return-hungry investors from successful ones is the ability to weigh the difference between risk and return.
Yes, investors with a higher risk tolerance should allocate more money into stocks. But, if those same investors do not have the conviction to stay invested through the short-term fluctuations of a bear market, they should reevaluate their exposure to equities.
Successful investors do not base their financial decisions solely on the S&P 500, the Dow and the Nasdaq, which is why it is extremely important to understand what those three indices represent.
Portfolio diversification cannot be addressed in a 30-second news clip.
But, most investment professionals agree that while it does not guarantee against a loss, diversification is one of the most important components to achieving long-range financial goals while minimizing risk. Keep in mind, however, even with diversification, there is always some element of risk.