How does an investor accurately answer how the market is performing when there are thousands of companies that comprise the stock market? This is the central purpose of a stock market index.
The oldest and potentially most well-known US stock market index is the Dow Jones Industrial Average, or the Dow. Established in 1896, the Dow tracks the price performance of 30 of the largest US companies. The composition of the Dow has changed over time to ensure the indexed portfolio remains relevant.
As revolutionary as this index was, there are two major criticisms. First, the Dow uses stock prices to track performance which can be easily manipulated (e.g. stock split, reverse stock split, stock dividend, cash dividend, etc.). In addition, only 30 stocks are being used to represent the performance of more than 1,000 US large cap stocks.
Counteracting these criticisms, Standard & Poor created the S&P 500 in 1957. This index uses market capitalization (i.e. overall market value of a company) rather than stock price to track performance.
It also uses a much larger sample size of 500 of the largest US publicly traded companies. The S&P 500 has been regarded by many financial experts as a superior representation of market performance for these reasons, that is, until recently.
Market trends have resulted in a few companies becoming so large, they dwarf the size of other typical companies. More specifically, Microsoft, Apple, Amazon, Alphabet (Google), and Facebook have captured approximately 25% of the market capitalization of the 500 stocks tracked by the S&P 500.
This means each company has an average weight of 5% versus a 0.2% weighting if each company was equal in size. Even though the index was built and intended to represent a large swath of companies, it is heavily influenced and largely tracking the performance of just five companies, leading to confusing or incorrect conclusions on how the overall market is performing.
To counteract this size bias, financial experts have started citing other indices like the Russell 3000 or S&P 500 equal weight. These indices give a much truer depiction of the overall stock market.
It will be interesting to observe if, and how, Standard & Poor attempts to remedy the issues plaguing their index. Until then, expect to see less recognized index names enter the conversation about how the stock market is performing today.
As always, if you have any questions or comments, please feel free to reach out to me.
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