Understanding the Stock Indexes

The suggestions and illustrations in this blog are not intended as financial advice. They are my personal opinions.

There are three major stock market indexes, which are the most widely quoted and significant market benchmarks: the Dow Jones Industrial Average, the S&P 500 Index and the NASDAQ Composite Index.

These three indexes reflect the changes in their components, which many individual investors use to measure the performance of their portfolios. However, there are better ways to measure. The proper way would be to categorize the portfolio’s positions into the index it would fall under and then measure the results against each index’s performance. There are also other indexes, and those categories should be included, too. For instance, small-cap shares should be measured against the Russell 2000 Index and not one of the three major indexes that are for large-cap companies. There are also categories within each index. For instance, the S&P 500 is for large-cap stocks; however, large caps can be divided into value and growth categories.

A comment here is that fully tracking the indexes takes more work. Perhaps a solution is to use one index as your tracking device, understanding that this would indicate the trends of your portfolio’s performance against the benchmark but not an exact measure.

To put this in perspective, most people invest in a wide range of stocks with many investors devoid of a disciplined strategy. Others invest in mutual funds where some fund managers engage in extensive trading within the fund, failing to outperform the indexes. Because of this, I suggest that a starting point for investing should be a fund that duplicates the S&P 500 Index. I might have younger people assume somewhat more risk and suggest a NASDAQ index tracking fund, while older people might assume less risk and suggest a Dow Jones Industrial Average index fund.

“Younger” and “older” are subjective terms and are based on the stage of life of the investor.

Additionally, I would provide different advice if someone were investing in a tax-sheltered account, such as an IRA or 401k plan, rather than a taxable one. This is because most tax-sheltered retirement accounts are inherently long-term investment accounts, and any interest, dividends and trading gains would not be currently taxed. Further, many participants in these accounts intend to use them to accumulate assets that would eventually generate “retirement” cash flow. That is a different motive than many accounts in individual names.

One of the characteristics I noticed about the three indexes is that on most days, the average percentage change of the Dow Jones Industrial Average and NASDAQ is pretty equivalent to the percentage change in the S&P 500 Index. This indicates that the S&P 500 is a pretty good mainstream average. It’s not a perfect measure, but it’s probably close enough for most purposes. That being said, the S&P 500 is pretty much what it is assumed to be, while the Dow Index is less risky, i.e., more conservative, and the NASDAQ has greater risk. Further, the NASDAQ is top heavy with high-tech stocks while the Dow is made up of the so-called blue-chip industrials with a spattering of high-tech and more stogy plowing away year after year essential companies.

On the dividend front, the Dow Index has the highest dividend payout and the NASDAQ the lowest.

Investing is complicated, important and serious. I believe its purpose is to have investors able to share in the growth of the worldwide economy, as it is reflected in the growth of the values of the shares of a diversified portfolio of the major American companies. I believe owning shares in a fund that duplicates the performance of the S&P 500 would accomplish this. Shares in a fund duplicating the Dow Index would do so on a lesser basis with less risk, while shares in a fund duplicating the NASDAQ would not accomplish this and would provide a greater growth opportunity with greater risk. Also, while investing in an index or mutual fund might reduce the specific risk in individual stocks, it will not reduce the systemic risk in the overall market and provide a shield to protect from widespread universal drops in the market. A comment about “worldwide” economic growth is that over 40% of the companies’ sales in the S&P 500 Index are generated outside the United States, thereby providing worldwide investment exposure.

I posted a blog on January 18, 2024, with a chart showing the top 10 stocks in each of the three indexes I mentioned here. Please be advised that updated charts can be found online. I usually update these once a year.

Please remember that the suggestions and illustrations in this blog are not intended as financial advice, and I share my personal opinions based on my experiences and untested conclusions. I suggest that you consider what I wrote but not make any decisions without consulting with your personal financial advisor and evaluating how your investment decisions would factor into implementing your overall financial goals and quest for eventual personal and family financial security.