Ep. 41: Knowing The Indexes
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Welcome back to Money Matters where I help guide you in becoming a better and more confident investor. Whether you find yourself picking individual stocks or maybe you are more of a fund investor. Either way, you need some type of metric for how your investment is performing. And depending on your asset allocation you could find you’re using different metrics of performance for different portfolios. And what I mean by that is you’re not going to use an investment portfolio with 50% bonds and other fixed-income investments and compare the performance to say the S&P 500, an index that has no fixed income. That would simply set you for underperformance and disappointment. If you’re investing in an ETF or mutual fund that tracks an index-investment, which has in recent years surpassed actively managed funds then you should be doing just as much research on the indexes they are tracking as you would on the fund manager of an active fund. In this video, I want to help you understand what’s going on with the big 3 major indexes that everyone should have on their radar so you have a better idea of what you’re invested in.
The most ubiquitous yardstick for investment performance is the S&P 500. This index is composed of 505 of the largest U.S. stocks by market capitalization. The idea behind this index is meant to be a barometer of the U.S. economy and equity markets. This index covers 80% of the U.S. stock market by capitalization. As this reflects what’s been going on with the U.S. economy we’ve all noticed how much big tech has been shaping our lives and the way business is done which the index then reflects that with tech comprising 23% of the index.
We then have the Nasdaq Composite. I still recall one of my first visits with my family to NYC and seeing the Nasdaq all lit up with the lights and the tickers of different companies valuations flying by and thinking it was the coolest thing. This index tracks about 2,700 stocks that trade exclusively on the Nasdaq exchange which is the first full-electronic stock exchange. This benchmark leans into the companies that fast-growing businesses are biased towards. So you are going to have technology stocks in that conversation which make up about 40% of this index. It’s important to note that the Nasdaq is market-cap weighted meaning widely held high-priced shares dominate, which is why it’s top-heavy in big-tech companies with high stock prices.
What some refer to as the grand-daddy of all indexes you have the Dow Jones Industrial Average. Going back to its creating in 1896 this index hold just 30 stocks. Which 30 companies make it into this index are decided on factors such as investor interest and the overall companies reputation, which goes against the usual quantitative way other indexes decide which companies to include. The Dow Jones as the name implies has larger allocations to industrials. Also has larger allocations to energy sectors and financials than the other two indexes which is by in larger with this indexes performance had been trailing the other two here in 2020. Instead of weighting stocks by market capitalization, the Dow weights it’s 30 companies by share price, allocating more assets to higher-priced names, regardless of the number of shares outstanding. This is why this index shies away from companies that have a very high share price. Given there are only 30 companies in the Dow, a high-priced name can have a disproportionate effect on performance. I find a lot of investors come to this index for solid returns from blue-chip stocks and the 2.4% dividend yield for 2020 which is currently the highest of all three indexes.
Over the past 15 years, the Dow and the S&P 500 have a 97% correlation to one another in terms of moving up and down. And the NASDAQ and the S&P 500 have a 95% correlation. So overall there is some overlap in these indexes, but it’s still important to give each one the different respect it deserves when choosing which investment is right for you. Know the benchmark you are using when comparing to the performance of your portfolio. It’s essential to truly understand the index you’re tracking.
Of course here at Colby Financial Guidance, I am here to help you in your investment journey and help you find the investments that align with not only the goals you’ve set out but the risks you’re willing to take on to get there. Thank you as always for watching, and giving your finances the attention that they deserve!
