Market Indexes Aren't Diversified as You Think

It is very common in our industry to compare personal portfolio returns to indexes. Two of the most common indexes referenced are the S&P 500 and the Dow Jones Industrial Average, also known as “The Dow”. Investors compare personal return to indexes, or benchmarks, to give them a sense of whether the portfolio is doing as it should…kind of a check and balance. That is a reasonable use of indexes, but unfortunately many investors are taking it too far. 

The Dow

Frankly, I can’t believe people still quote the Dow. Decades ago, without technology, it may have been a suitable proxy for the overall market - but not today. The Dow consists of only 30 stocks, most of those “industrial” in nature. Not only is it undiversified, but it is a price weighted index. That means that stocks with high share price have greater influence on the index value than those stocks with low share prices. If IBM were to split its stock two for one, their influence on the index would be cut in half. That is ludicrous and certainly not worthy of serious comparison to a personal portfolio of diversified securities.

The S&P 500

The S&P 500 is a beloved, but very imperfect proxy for portfolio performance. Most investors think, “Wow, it has 500 stocks, it is really diversified.” Not really. Those 500 stocks are of large US companies, and the index is capitalization weighted. That means the largest companies carry more weight in calculating the index value than smaller companies. While this isn’t as perverse as a price weighted index, it poses some challenges. For instance, the three companies of Microsoft, Apple and Alphabet (parent of Google) have a greater influence in the value of the S&P 500 index than the entire sectors of utilities, telecom and materials.1 So three companies carry more weight than three sectors. I wouldn’t call that diversified. 

My Thoughts

Unless you want your portfolio largely dependent on the outcome of a handful of stocks, religiously comparing your portfolio performance to that of a market index is not a good comparison on the basis of diversification alone. Add in the difference between investors and indexes with respect to risk (indexes don’t manage risk) and time horizon (indexes have infinite time horizon), and you will understand why I strongly discourage comparing your return to market indexes.

 

  1. Wall Street Journal, Tech Shares Fade as Earnings Approach, April 14, 2017

Disclosures

The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. All indices are unmanaged and may not be invested into directly.

The Dow Jones Industrial Average Index is comprised of U.S.-listed stocks of companies that produce other (non-transportation and non-utility) goods and services. The Dow Jones industrial averages are maintained by editors of The Wall Street Journal. While the stock selection process is somewhat subjective, a stock typically is added only if the company has an excellent reputation, demonstrates sustained growth, is of interest to a large number of investors, and accurately represents the market sectors covered by the average. The Dow Jones averages are unique in that they are price weighted; therefore, their component weightings are affected only by changes in the stocks’ prices. It is not possible to invest directly in an index.