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What’s in an Index? Thumbnail

What’s in an Index?


What Exactly is the "Market?"

Every day you hear on the news that the “market” went up, or the“market” went down. Too often, we take that information at face value and allow it to shape our opinion of how our investments must be performing. But what exactly is this “market” to which the newscasters are referring? Well, it depends on who you’re listening to or reading, but most professionals are referring to one of two indexes, the Dow Jones Industrial Average (the Dow) or the Standard & Poor’s 500 (S&P 500).

The major difference between these two indexes is that the Dow Jones Industrial Average includes a price- weighted average of 30 stocks whereas the Standard & Poor's 500 is a market value-weighted index of 500 stocks. Component stocks of the Dow are selected by the index committee, a group that includes editors of The Wall Street Journal, which is published by Dow Jones & Co., a part of News Corp. S&P 500 stocks are chosen by anS&P committee, which moves companies in and out annually, if not more often, as mergers and acquisitions occur throughout the year.

The Dow Jones Industrial Average

The Dow is comprised of 30 of the largest companies in the U.S. across a range of industries, though not always all industries. The criteria for a company to get on the Dow is vague. The companies are leaders in their industry and very large. The components in the Dow do not change often as it takes an important change in a company for it to be removed from the index, and if the index comes up for review, the Wall Street Journal editors often replace more than one company at a time. Their most recent addition has been Apple, which replaced AT&T this year. The Dow tends to include more mature, less volatile companies, making the index less vulnerable to sharp moves. Apple shares tend to swing almost twice as much as AT&T’s, so it will be interesting to see if that changes the volatility of the Dow Jones. As investors have been forced into the markets in their hunt for yield, it will also be interesting to see if volatility is impacted by investors leaning more on Dow-related companies.

Standard & Poor’s 500

The S&P 500 is comprised of 500 large companies from a vast number of industries, picked based on four criteria. First, the company’s market capitalization must be more than $5 billion. Second, the company needs to have four consecutive quarters of profit based on a specific equation.Third, the company must have adequate liquidity, which basically means a large volume of shares trades daily. The fourth and final piece of criteria isa public float of at least 50%. The S&P only includes companies they determine to be “operating”, which excludes securities such as closed-end funds, holding companies, partnerships and royalty trusts. The goal of the index is to closely match the sector weighting that is seen when you combine all stocks above $5 billion.The purpose of these two indexes (and there are many other indexes as well) is to determine the general trend of the market. They each arguably have their flaws.One may have too few companies to be a solid and broad representation of the markets, while the other may be more susceptible to the movement of the stocks with the largest market capitalization. The problem with market capitalization is that the stock carrying the largest percentage ownership in the index is vulnerable to concentration. As a company increases in value, so, too, does its weight in the index. This, in turn, means the index's performance is more greatly influenced by the movements of the stocks with the heaviest weightings, and therefore can become susceptible to sector-specific risk allowing one (or a few) sectors to drive the returns.

The Takeaway

The importance of understanding the indexes is to give you a broad look at what is happening in the markets in general. But to make a good investment, you need to dig down into the indexes to find the companies where value is being created and to uncover great buys that could be ripe for the picking.

If you are unsure where to start, The Popovich Financial Group can help you make sense of the markets with a personalized financial plan and customized investment portfolio designed to help achieve your specific investment goals. ©Robert W. Baird & Co. Member SIPC. MC-48882.

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