In the 21st century access to information is more readily available than ever before. When it comes to the “markets” the Dow and the S&P 500 seem to be the most seen, talked about, and followed indexes in the United States. But very few people know what they are looking at or stop to ask if what they are looking at is relevant to their situation.
So, what is the Dow and what is the S&P 500 and are they relevant to my portfolio? Over the course of the next three posts I will give a brief explanation of the two indexes and then finish up with the, “are they relevant to me” question.
Each of these indicators, the Dow and the S&P 500, is an index*. The purpose of the index is to give a general idea of the movement of “the market” over a given period. They are also often used either on their own or paired with other indexes to create a benchmark for an investor to measure their portfolio against.
The Dow Jones Industrial Average is arguably the most popular and well known of the indexes in the market place. It is made up of 30 large, well-known US stocks that are traded on the New York Stock Exchange. The Dow was created in 1896 by Charles Dow and was originally 12 US corporations. It was expanded to 20 corporations in 1916 and then moved to the current count of 30 in 1928. It is owned and maintained by the Wall Street Journal. The 30 stocks that compose the Dow must satisfy a list of criteria to be added and included in the index. If a stock that is in the Dow does not meet one of the criteria, over time it may be removed and replaced by another stock.
Though the Dow is popular among investors and the media, it has two weaknesses when it comes to using it as a benchmark for measuring your portfolio. One, the way its return is calculated. The Dow uses a price-weighted average for calculating its return which gives more importance to a stock’s price rather than its actual size in the portfolio. Two, the Dow only represents 30 stocks in the US market which is a very small portion 4300 stocks that are traded on the US markets.
With the price weighted calculation and a small number of stocks, the Dow can vary widely day to day if one of its stocks has a volatile day. This is why you may notice the variance in the Dow’s daily results compared the results of the other indexes or even your own portfolio.
In the next post I will discuss the S&P 500, looking at its pros and cons in the return calculation and the makeup of the index. We will finish up the following week with the question of relevance as a portfolio benchmark.
*An index is not managed and cannot be invested into directly.