What’s in an Index?

As much as I try to avoid the noise and focus on what matters to our clients and the investments we hold, I still find myself getting frustrated when I see the financial (and many other) news outlets reporting on the levels of the Dow Jones Industrial Average (aka The Dow or DJIA). Why is that? I am not totally sure! Whether you know it or not, the Dow is comprised of only 30 large US companies that are somewhat arbitrarily selected by a committee. Many (including me) argue that this index severely underrepresents the US stock market and is not the best indicator.

When the Dow was originally created in 1896, the companies that made up the index were all from the industrial sector (gas, cotton, railroads, etc.). The committee that picks the stocks in the index will add or drop companies based on perceived changes in the marketplace (or stock performance), and those companies are now much different than the original “industrials.” To further complicate things, the higher the share price of a company, the more weight it has in the index.

Below is a list of the companies included in the Dow as of June 2022.

A more representative index to follow is the S&P 500, which is much broader and consists of over 500 different companies traded on different exchanges (but the components are also selected by a committee). While it’s not perfect, I believe it is a far better indicator of the US stock market than the Dow. And, each company is weighted based on its market value vs. the Dow’s price-weighting. The higher-market weighted stocks will have an outsized effect on the index performance, but that makes more sense to me that the price-weighted tilt of the Dow.

Here are the top 11 components of the S&P 500 by weight as of today. You can see from the names why they might have a larger effect on the price of the index vs. other companies.

In today’s market, there are hundreds of different indexes that range from the very broad (MSCI All Country World Index or ACWI) to the very narrow (like the MSCI China Small Cap Index). So, if you are looking to compare your investment performance vs. an index or another portfolio, make sure that the index or portfolio to which you are comparing comes close to your actual investment mix.

To attempt an answer to my own question at the beginning of this post, I suspect that it’s “because that’s how it’s always been.” It’s hard to argue that the Dow is still as relevant as it once was back in the early 1900s, but it is still front of mind for many investors who track stock market performance. Just make sure you are comparing apples to apples when looking at your particular rate of return vs. other investments out there.

For example, don’t compare the performance of your Apple and Meta stock to the performance of your retired uncle’s dividend-paying stock and bond portfolio! (although, he may be doing much better than you year-to-date 😊). That’s like comparing the fish that my son caught in the pond down the road to the striped marlin my friends and I caught last week!

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