Before going into the individual indices (e.g., the Dow), here are a few reasons I recommend ignoring any reports of changes in these indices, certainly on a daily basis:
- They are not representative of your portfolio.
- Long term investors should ignore short term fluctuations in the market.
Regarding point 2, I don't recommend that you pay any attention to short term changes in your portfolio, much less short term changes in indices that don't even represent changes in your portfolio. It's widely understood that the price you pay for the probability (but not certainty) of superior long term investment returns is higher short term volatility. So, if you've made the decision to invest in anything other than cash and cash-like instruments, it's a certainty that the value of your portfolio will fluctuate. Some days, weeks, months or years it will be down (sometimes a lot), and sometimes it will be up (historically, more often).
So, rather than spend time worrying about changes in the Dow (or any other index), spend time reading a good book on investing. For some suggested books to read, see my recommendations here.
Having said all of the above, if you're still interested in the Dow, the S&P 500 and the Nasdaq, read on.
The Dow
First, although according to the investorwords.com definition of the Dow, the Dow is "The most widely used indicator of the overall condition of the stock market", it's probably not a good indicator of how your investment portfolio is doing.
First, the Dow is made up of only 30 stocks, so it isn't representative of the broad US market, and certainly not of the foreign markets (and hopefully your portfolio is made up of these broader markets, and not the 30 Dow stocks).
Second, reporting the change in "points" is not very useful, since it doesn't tell you the percentage change, which is more relevant. If the Dow were at 10,000, a 100 point change would be 1%; if the Dow were at 5,000, a 100 point change would be 2%. This criticism of reporting index changes in points instead of percent applies to all indexes.
Finally, the Dow is a price weighted index, whereas most modern indexes are cap weighted. Now this is a technical point, but it's actually an important one. What it means is that the higher the price of a particular stock in the Dow, the more impact it has on the index, even if it's the stock of a smaller company than another one in the index. Modern, cap weighted indexes are influenced more by the moves of larger companies than smaller ones, which makes more sense.
Yes, if the Dow went up 100 points, the large cap US stock portion of your portfolio probably went up, and it's very likely that it went up somewhere in the neighborhood of 1%, but it's likely that the international (foreign) and US small cap portions of your portfolio performed quite differently on that particular day.
My advice (and that of many other highly respected financial researchers, authors and advisors): ignore the Dow!
The S&P 500
According to the investorwords.com definition of the S&P 500, the S&P 500 is "A basket of 500 stocks that are considered to be widely held". This index overcomes the major flaws of the Dow. It's a much broader index, representing over 70% of the total US market value, and it's capitalization weighted (changes in the stock values of larger companies have a bigger impact on the index). The percentage change in this index is likely to closely represent the percentage change in your broad US stock holdings (e.g., a total US stock market index fund).
Again, knowing the change in points is worthless -- you need to know the percentage change to get an idea of how the large and mid cap portions of your US portfolio probably changed.
The Nasdaq
The Nasdaq itself is actually a stock exchange (a marketplace where stocks are bought and sold), not a stock index, so when you hear reports of the Nasdaq changing so many points, the reporter actually is referring to either the Nasdaq Composite Index or the NASAQ-100, the former being a cap weighted index of all stocks traded on the Nasdaq exchange, and the latter being mostly the largest 100 companies traded on the exchange.
Like the Dow, the Nasdaq indices are not representative of the broad market, since the Nasdaq is heavily weighted by technology stocks. So, unless your portfolio is heavily weighted toward tech stocks, you can ignore the reported changes in the Nasdaq indices.
Received this question in an email: Could you say just a little more about cap weighted indices—is that how these companies relate to one another proportionally within the Dow or S&P Index?
ReplyDeleteA cap-weighted index (also referred to as market-weighted) is one in which the effect a company's stock has on a change in the index value is proportional to the total market value of the stock. The total market value of a stock is the number of shares outstanding (available for buying and selling) times the price per share.
Let's look at a highly oversimplified example to see this more clearly.
Let's say that an index consists of the stocks of 2 companies: A and B. The total value of company A's stock is $1B (one billion dollars) and that of company B's stock is $100M (one hundred million dollars or $0.1B). So, the total index value is $1.1B, and company A makes up 91% of the index value and company B makes up 9%.
Now say company A's stock increases 1% today and company B's stock doesn't change. The value of the index increases by 1% of $1B or $10M ($0.01B), so the value of the index increases to $1.11B or 0.91%.
However, if company B's stock had increased by 1% and company A's stock had remained unchanged, the index value would've increased by 1% of $0.1B or $0.001B ($1M), and the index would've increased to $1.001B or 0.09%.
Most academics and economists believe that this is as it should be; i.e., that the larger the market value of a company, the larger the impact on the index.
However, since the Dow is price weighted, in the above example, if company B's stock was priced higher than company A's, it would have a larger impact on changes in the index, even though it's market value is much less. This just doesn't make any economic sense, and is the Dow is a flawed index.
Last sentence of previous post should've read:
ReplyDeleteThis just doesn't make any economic sense, and is one reason the Dow is a flawed index.