If you watch the news, you’re probably familiar with the S&P 500, the NASDAQ, and the Dow Jones Industrial Average (DJIA). Depending on the source, they’re usually featured at the bottom of the screen or in a corner and are followed by flashing numbers in red or green depending on whether the numbers are decreasing or increasing. You’ve probably figured out that it’s good when the numbers end the day higher than they started, but you may not know why that is or what the difference is between the indexes. You may not even care, but I think you should and here’s why:
Most people use indexes like the S&P 500 and the DJIA to determine whether or not they’re pleased with their investment’s performance. The problem with this approach is that when you don’t know what’s in the index (or what’s in your portfolio for that matter) you have no way of knowing whether or not you’re comparing apples to apples or an apple to a kumquat. Indexes can actually be incredibly helpful for judging performance, but only when you know how they work can you know whether or not they’re comparable.
There are three major types of indexes: price-weighted, value-weighted, and equal-weighted. There are others, but these are the important ones. In a price-weighted index, the amount allocated to each stock is based on its current share price. For example: if we had a price-weighted index of three stocks with Stock A trading at $50, Stock B trading at $30 and Stock C trading at $20 (50+20+30 = 100) then we would allocate 50% of the index to Stock A (50/100 = 50%), 30% of the index to Stock B (30/100 = 30%), and 20% of the index to Stock C (20/100 = 20%). The advantage to this type of index is that it’s simple – you just buy one of everything. The downside is that the stocks with the higher prices end up being a greater portion of the index, which can be dangerous if it turns out that those stocks are overpriced. The DJIA is the most well-known price-weighted index in addition to being the oldest index (it began in 1896). It is comprised of 30 large, mature, blue-chip stocks chosen by Wall Street Journal editors. Interestingly, General Electric is the only one of the original 12 stocks that’s still in the index (it has disappeared and reappeared several times over the years). You can see a current list of stocks that make up the Dow Jones Industrial Average here.
In a value-weighted index, each of the stocks in the index are weighted based on the size of the company which can be found by multiplying the number of shares outstanding for that company by the price they're trading at. This is also known as the market capitalization of the company. For example: if we have an index with three companies and Company A has a market cap of $500mm, Company B has a market cap of $300mm, and Company C has a market cap of $200mm, then I would allocate 50% of my index to stock in Company A, 30% of my index to stock in Company B, and 20% of my index to stock in Company C. The S&P 500 is a value-weighted index of the largest 500 companies in the United States. You can see a list of stocks that make up the S&P 500 here. The advantage of this type of index is that it’s easy to maintain because as stocks appreciate in price they automatically become a larger portion of the index. Because this type of index adjusts for changes in price on its own, value-weighted indexes require significantly less trading which make them much more cost effective. The downside of this index is that it results in greater allocations to giant companies and smaller allocations to smaller companies which often have greater growth potential.
As the name suggests, an equal-weighted index is one in which each of the stocks are weighted equally. For example, using our same three stocks, an equal-weighted portfolio would have 33.33% of Stock A, 33.33% of Stock B, and 33.33% of Stock C. Equal-weighted indexes are the easiest to understand conceptually, but also require frequent rebalancing to maintain the equal weights which can be costly.
Other helpful indexes to be aware of are the NASDAQ which is a value-weighted index of all of the stocks traded on the NASDAQ exchange, the Russell 3000 which is a comprehensive value-weighted index of the largest 3000 companies in the U.S., and the MSCI indexes which are a series of value-weighted indexes based on regions (the MSCI ACWI is a market index of the whole world). For most individuals with a well-diversified portfolio, it’s unlikely that only one index is sufficient to compare performance to. For one thing, these are all equity indexes, which means that if you have any portion of your portfolio allocated to bonds, you need to consider a whole other set of indexes in order to make helpful comparisons. The point is, before you try to make comparisons, make sure you know what it is that you’re comparing and whether or not they’re actually similar things.
Institute, CFA. 2016 CFA Level III Volume 4 Fixed Income and Equity Portfolio Management. CFA Institute, 07/2015. VitalBook file.