Like "Me and my shadow," the Dow Jones industrial average and the S&P 500 index are major benchmarks that could walk their miles in each others' moccasins ... or each others' Manolos. Women, after all, are said to own greater amounts of stock than men in this country thanks to inheritance, longer life spans, and their superior investment acumen due to less compulsive behavior.
But I digress. The Dow Jones industrial average of 30 large companies just generated some publicity for itself last month when it kicked Bank of America, Hewlett-Packard (HPQ) and Alcoa off its list. In their place came Goldman Sachs, Nike and Visa. Why this would matter to the average investor is debatable, but the Dow is a major benchmark that serves as a barometer for stock market movement. It's the one we generally seize upon when we're wondering what the market did today.
While the Dow is represented by just 30 stocks, the S&P 500 is a weighted average of the largest 500 companies based on their size in stock market value. This means that a handful of the nation's largest companies dominate the value of the S&P index. Just a handful of large companies make up almost half the value of the whole index. This alone explains why the Dow, made up of just 30 hand-picked huge companies, winds up with results similar to the larger universe of the S&P 500. The largest 500 companies, by the way, make up 70 percent of the entire stock market's capital value, while the remaining 6,000 public companies constitute only 30 percent, which goes to show how big the big ones are.
How close do these indexes track together? Well, my rudimentary comparison compounding returns on an annual basis for the past 10 years gives them both a 6.34 percent average annual return. One hundred dollars invested in either one would have compounded to $184. The actual results would have been slightly higher -- about 7 percent per year for each -- because of the effect of dividends.
While the S&P and its weighted average value is easy to understand, the Dow is more complex. It is based on the average share price of the shares in the fund. But that doesn't mean it's as simple as adding up all the share prices and dividing by 30. Otherwise, we'd never have a number like 15,000 for the Dow. Over the years, the average has factored in all of the stock splits, spinoffs, mergers and other activity that make up the true value of today's share prices. Also, companies with larger stock prices make the other companies in the mix less relevant. But in the end, it all comes together as a proxy for what the entire stock market is doing.
Movement of the entire market, of course, is like the rising and lowering tide that raises or lowers all the ships. With occasional notable exceptions, 70 percent of any single stock's movement is a function of what the entire market is doing.
So, how do we beat the averages? We consider taking more risk. The invisible hand of economic forces rewards investors who can live with more volatility. There are hundreds of index funds today that provide a cross section of specific subsets of the stock market. For example, a small cap index measures the returns of a cross section of small public companies. Over the past 10 years, this index has earned at a rate of 8.81 percent per year. In the small company arena, yesterday's $100 has compounded to $232 over the recent 10-year period. While small companies have not won out like this over all 10-year periods, they have generated returns of roughly 2 percent per year higher than the broad market averages over long periods. Two percent may not sound like much, but on a $10,000 per year investment over 30 years, it adds up to an additional $1 million.
Benchmarks and broad market averages are interesting points of reference, but when it comes to investment strategy, it pays to assess your comfort level with different risk elements and consider more diversification.
Stephen J. Butler is CEO of Pension Dynamics. Contact him at 925-956-0505, ext. 228 or firstname.lastname@example.org.