Too often, investors measure the success of their portfolios or the effectiveness of their financial advisors relative to the performance of well-known stock market indices.
While it is important for investors to have a tool to measure the success of an investment strategy against, it can be misleading if an investor chooses an index that is not consistent with their risk tolerance or investment objectives.
Think about this in a different way.
Imagine you want to buy a house. How do you start the planning process?
Do you look at everyone around you who is purchasing a home and do exactly what they do? For example, do you buy one at the same price, the same size, in the same area, with the same mortgage company? Technically you could, but it would not be smart.
In reality, you would first determine how much you could afford to pay monthly, research what neighborhood you want to live in, and find a mortgage that works for your financial situation.
It is the same with your investment portfolio. Why would you compare your investments to a benchmark that does not represent your finances as a whole?
In this article, I will discuss the three most popular stock market indices and the potential pros and cons of comparing your investment portfolio to them.
Popular U.S. Stock Market Indices
Dow Jones Industrial Index (DJIA)
The DJIA is a price-weighted average of the stocks of 30 large U.S. publicly traded companies.
A price-weighted index is a stock index in which each stock influences the index in proportion to its price per share. A stock with a higher price will be given more weight than a stock with a lower price. A list of component weights of stocks in the DJIA can be seen here.
There are no specific rules for a company to be included in the DJIA. However, for a company to appear in the index, it must account for a significant portion of U.S. economic activities. Also, components of DJIA come from all industries except for transportation and utilities.
S&P Dow Jones Indices maintains the DJIA. Changes to the index are made at the discretion of the Averages Committee on an as-needed basis.
Since DJIA only contains 30 companies, it is not a great benchmark for evaluating the broad stock market. Additionally, since it is a price-weighted index, it may be misleading. This is because stock prices may not reflect companies’ true value.
S&P 500
The S&P 500 is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies by market value.
A market-capitalization-weighted index is a stock index in which each stock influences the index in proportion to its market capitalization. A stock with a bigger market-capitalization has more weight than a stock with a lower one. One can calculate market capitalization by multiplying the current stock price by the amount of shares outstanding. For example, a company with 20 million shares selling at $100 a share would have a market cap of $2 billion. A list of stocks that make up the S&P 500 can be seen here.
At the time of this article’s publication, in order for a company to be included in the S&P 500 it must meet multiple requirements. For example, a company’s market capitalization must be greater than or equal to $6.1 billion dollars.
Like the DJIA, a committee manages the S&P 500 instead of a formula or set of rules.
Compared to DJIA, the S&P 500 is a broader representation of the U.S. market due to its inclusion of 500 companies.
Nasdaq Composite Index
The Nasdaq Composite Index is a market-capitalization-weighted index of over 3,300 equities listed on the Nasdaq stock exchange. At the time of this publication, the technology sector makes up of around half the Nasdaq composite index.
There are multiple rules that must be met for a company to be included in the Nasdaq Composite Index. A complete list can be seen here.
Like the DJIA and S&P 500, the Nasdaq Composite Index is managed by committee that can exercise discretion when deemed appropriate.
Since the Nasdaq Composite Index is heavily tilted toward technology equities, it is not a broad representation of the stock market.
Conclusion
If you have a diversified portfolio, comparing it to an index may not be the best way to evaluate returns. This is because a proper diversified portfolio contains investments in many asset classes (Domestic, International, Bonds, Alternatives, etc.). An index is not set up to track multiple different asset classes. Therefore, it is unfair to compare your portfolio’s returns to that of an index.
In my opinion, it is easier to benchmark each individual investment. Depending on your risk tolerance and investment goals, this can be tricky too. Thus, you should seek out the help of a qualified financial advisor.
