The Dow, S&P 500 and “the market”— Keeping it All Straight
In recent months, the fact that the Dow Jones Industrial Average broke the 20,000 mark was huge international news.
But why? What do these numbers refer to and what do they have to do with a balanced portfolio?
Let’s start with the basics.
What do people mean when they refer to “the market?”
In common parlance, most people rather loosely refer to the sum of all domestic equities as “the market.”
The trouble is, the media doesn’t often take on the difficult task of reporting on “the market.” Instead, they report on specific indexes, most commonly, The Dow Jones Industrial Index, S&P 500 and NASDAQ composite index. Then they — often inaccurately — try to draw correlations between the way these indexes perform and the broader market of domestic equities. Not only does this lead to confusion about why some stocks go down on any given day while the supposed “market” is up, it also neglects the other elements of the market, such as bonds.
What do these indexes measure?
Most indexes measure the sum of the closing price of a specific list of financial instruments. There are hundreds of different indexes, though the ones commonly reported on in the popular press typically measure equities, specifically:
Dow Jones Industrial Average (DJIA) is one of the oldest and most well-known indexes. It measures the stocks of 30 of the largest and most influential companies in the United States. Despite often being used as a stand-in for the entire market, it only measures about 1⁄4 of the value of U.S. equities.
The Standard & Poor’s 500 (S&P 500) is made up of 500 of the most widely traded stocks in the U.S., representing about 80% of the total value of U.S. stock markets.
The NASDAQ Composite is an index of all stocks traded on the Nasdaq stock exchange. This index includes some companies that are not based in the U.S., including many in technology.
Indexes and the Diversified Portfolio
All of these indexes and many of the others use complex formulas that give a real-time measurement of their portion of the total market. NONE of them represent your diversified portfolio.
If you are staring at the Dow Jones index day in and day out and are using that as your “success” benchmark, you will not be seeing the full picture. The key to managing risk and achieving your goals is diversification — that is, investing in different asset classes to reduce risk and protect your portfolio’s performance of a single security, industry, etc.
A single index cannot and will not show this. And, more importantly, comparing the performance of one of these indexes is like comparing apples and coconuts – they’re similar but not THAT similar.