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Why Investors Shouldn’t Just Rely on the Dow

When assessing the health of the stock market, it’s easy to look at whatever index is ticking across the bottom of a cable business channel at that moment. Commonly, news anchors and reporters comment on the Dow Jones Industrial Average (Dow), citing milestones when new highs are hit or losses occur.

While we don’t want to demonize the Dow, we caution investors to avoid fixating on this particularly popular index. The Dow may be a poor indicator of the market overall as it only tracks 30 large public companies in the country, based on price. A price-weighted index is proportionally influenced by price per share as opposed to market capitalization weighted, as is the case for most indices. For example, Boeing is currently at the top of the Dow because it’s the highest-priced stock in the index. Aside from being price weighted, the Dow doesn’t provide great breadth because it tracks only a small fraction of the more than 3,000 public companies in the U.S.

Conversely, many of the other indexes are market-cap weighted and take into account the size of a company based on its current stock price and outstanding shares. In addition, these indexes track hundreds to thousands of companies as a benchmark. Having a more diverse data set to pull from can help provide a greater understanding of overall market, sector, and general health of the economy. The S&P 500 tracks the 500 largest companies in the U.S. that have stock listed on three different exchanges. Likewise, the Russell 1000 tracks the 1,000 largest companies by market capitalization in the Russell 3000 Index, while the Russell 2000 tracks the 2,000 smallest-cap stocks in the Russell 3000. As a result, these indexes provide a broad representative look at their respective areas of the market.*

Another index you might hear about frequently is the Nasdaq, which tracks primarily healthcare and technology stocks. Since the Nasdaq focuses only on these specific sectors, it’s not a great representation of the market at large. Rather, it offers a good gauge of a particular market subset.

It’s critical for investors to understand each of the indexes and what role they play in each area of their portfolio. When evaluating their investments, investors might consider index funds that can align with certain indexes. If retail investors are in index funds, they need to know that they won’t “beat” the market because these funds are the market. Before selecting any investment, it’s critical to do your research. Determine what an index fund is tracking by looking at the fact sheet and prospectus so you can understand what you’d be buying.

Having a solid understanding of the indexes and setting expectations will be fundamental to trying to reach your investment goals. If you have any questions or want to talk about investing strategies, contact a Girard Advisor to start the discussion.

 

*The indexes referenced in this article are comprised of stocks considered to be representative of the particular market they are designed to track. These indexes are unmanaged and cannot be invested in directly.

These articles and reports are for general information purposes only and are not intended to provide legal, tax, accounting or financial advice. The information in these articles or reports, and any opinions expressed therein, do not constitute a recommendation or an offer to buy or sell any security or financial instrument. Viewers should consult with their financial and/or legal professionals before making any financial decisions.