What Are the Dow and S&P 500, and Should You Compare Your Portfolio Performance to Them?
Each month, we book time with some of our company’s top financial brain power to answer questions about investing and your finances. This month we’re talking about names you probably hear a lot, the Dow Jones Industrial Average and the S&P 500. What are they really? And should you compare the performance of your portfolio to them?
Do you have a question for our financial experts? Email it to us at: AskTheExpert@northwesternmutual.com
The following is an excerpt from our Ask the Financial Expert podcast (listen to the entire podcast below):
Mark: The markets have been in the news a lot recently. Most people hear headlines or the talking heads mention the Dow or the S&P 500 in reference to financial news. But what are those indexes really measuring? At the basic level, what is the Dow and what’s the S&P 500?
Ron: I think if it weren’t for the history of the Dow Jones Industrial Average, it probably wouldn’t exist today. But it’s been around since the late 1800s, and because it’s been around so long, it really took hold in the investment community.
It’s basically a measure of 30 different companies that are determined by a small group of individuals. It’s called the Dow Jones Industrial average because the companies were originally industrials. Today they’re just 30 large companies.
First, it’s not really representative of the market, so you need to be careful about that. Second, it’s calculated on a price average basis. It is adjusted for splits, but nonetheless it’s price average. So what ends up happening is large companies with higher prices will tend to have a much higher impact than companies that just happen to have lower prices. Because of that, I think it’s less representative of what you might be interested in as an investor.
The S&P 500 is different. The stocks that make up the index are also selected by a group of individuals. A lot of people think it’s just the 500 largest companies, which is not the case. The companies are selected based on a variety of factors: market capitalization, liquidity, float, sector, financial viability. There are a whole bunch of different measures. There are some rules in the 500, for example, the market capitalization has to be at least a certain amount—I think it’s about $5 billion. Unlike the Dow, it’s not price adjusted. The S&P 500 is market cap adjusted, which probably is a better measure. A lot of people think the S&P 500 is all U.S. It’s not; there are more than two dozen foreign-based companies.
So it is a more important index, but probably the most important thing is that it is basically a representation of large cap and leaves out a lot of other companies that I think are important, like mid cap and small cap.
Mark: I know many advisors use the S&P 500 as a benchmark for their large cap holdings, whereas I don’t think many people use the Dow Jones as any kind of benchmark for performance. Would it be good for an investor to compare his or her overall portfolio to either the Dow or S&P?
Ron: People do it all the time. It’s not generally a good benchmark because people’s actual portfolios typically have a very different risk profile than the S&P 500. And if advisors are doing what they should be doing and they’re trying to understand the client’s risk profile, then it may be something that’s very different than the S&P 500.
So there are a lot of reasons why the returns our clients should be getting may, at times, look much better or much worse than the S&P 500. It doesn’t mean that anyone’s doing a good or a bad job, necessarily. It may be simply reflective of the combination of assets that you have that reflects your risk tolerances.
The fact of the matter is, even if you’re somebody who says, “I want to be 100 percent invested in stock,” that’s great; but what about mid cap and what about small cap? Those are very different profile and return characteristics than the large cap. Even investors who have decided they want to be fully invested in equity may not necessarily expect their returns to reflect the S&P 500 because there are other ways to invest in equities.
Hear more from Ron and Mark in the “Ask the Financial Expert” podcast:Do you have a question for our financial experts? Email it to us at: AskTheExpert@northwesternmutual.com
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