Understanding The Major Indices

Recently on CNBC, the commentators were remarking on a sharp divergence in two of the most popular stock market indices. One was up, and the other was sharply down.

I thought about that for a moment, and then wondered whether most people understand what these indices represent, and what they are composed of. I decided that the answer is “Probably not”, so I decided to write a column about it.

First, what is a stock market index? It is a basket of stocks that represents some segment of the stock market. There are broad-based indices that cover large segments of the market, and then there are more specialized indices that cover narrow segments. For example, there are indices that cover only the technology sector, but more narrowly there are indices that cover just solar companies.

While the list of indices is huge, there are three major indices that investors often hear about: The Dow, the S&P 500, and the Nasdaq. Let’s discuss each in turn.

The Dow

The Dow Jones Industrial Average (DJIA), which is usually simply called “The Dow”, is one of the oldest and most frequently-cited stock market indices. The index was created in the late 1800s, and measures the performance of 30 large U.S. companies. The 10 largest companies in the Dow and their percent weighting are:

1. UnitedHealth Group (NYSE: UNH) – 7.49%
2. Goldman Sachs (NYSE: GS) – 6.51%
3. Home Depot (NYSE: HD) – 6.04%
4. Amgen (NSDQ: AMGN) – 5.03%
5. Boeing (NYSE: BA) – 4.87%
6. Microsoft (NSDQ: MSFT) – 4.70%
7. Caterpillar (NYSE: CAT) – 4.57%
8. McDonalds (NYSE: MCD) – 4.48%
9. Honeywell International (NYSE: HON) – 4.35%
10. Visa A (NYSE: V) – 4.25%

These 10 companies make up just over 50% of the weighting of the Dow. The problem should be immediately clear. This is a really narrow slide of the U.S. economy, and therefore movements in the Dow may not track with broader market movements.

The S&P 500

The index I follow most closely is the S&P 500. The Top 10 components are:

1. Apple Inc. (NSDQ: AAPL) – 5.75%
2. Microsoft Corporation – 5.3%
3. Amazon (NSDQ: AMZN) – 3.94%
4. Facebook Inc. Class A (NSDQ: FB) – 2.03%
5. Alphabet Inc. Class A (NSDQ: GOOGL) – 1.85%
6. Alphabet Inc. Class C (NSDQ: GOOG) – 1.78%
7. Tesla Inc (NSDQ: TSLA) – 1.49%
8. Berkshire Hathaway Inc. Class B (NYSE: BRK.B) – 1.45%
9. JPMorgan Chase & Co. (NYSE: JPM) – 1.42%
10. Johnson & Johnson (NYSE: JNJ) – 1.29%

Although the S&P 500 has become more technology-heavy in recent years, the Top 10 holdings only represent 26% of the index. Further, as the name implies the S&P 500 is composed of 500 of the largest companies in the U.S., representing 70 to 80% of the total U.S. stock market capitalization. Therefore, it is a more reliable indicator of the healt of the markets in the U.S.

The Nasdaq

Finally we come to the Nasdaq. Note that many of the previous companies have the symbol “NSDQ”, and that means they trade on the Nasdaq stock exchange. The Nasdaq Composite is an index that includes almost all stocks listed on the Nasdaq stock exchange. The Top 10 holdings in the Nasdaq Composite index are:

1. Apple
2. Microsoft
3. Amazon
4. Tesla
5. Facebook
6. Alphabet Class C
7. Alphabet Class A
8. NVIDIA Corp (NSDQ: NVDA)
9. PayPal (NSDQ: PYPL)
10. Netflix (NSDQ: NFLX)

The Nasdaq is the most technology-heavy index. It’s a good representation for technology investors, but this index can diverge sharply for broader market investors.

Comparing the Three

In recent years, the Nasdaq has outperformed the other two major indices. But it suffered a pullback earlier in the year, and now lags both the S&P 500 and the Dow. Year-to-date, the performances of the three indices are:

1. Dow – +9.4%
2. S&P 500 – +7.4%
3. Nasdaq – +3.5%

Longer term, however, there is no contest. Over the past five years the Nasdaq has blown away the other two indices. The performances over the past five years are:

1. Nasdaq – +167.3%
2. S&P 500 – +91.8%
3. Dow – +85.9%

Just remember that the type of investor you happen to be will strongly influence which index may most closely represent your own style. If you happen to invest primarily for income, then perhaps none of these indices are good representations, although the Top 10 in the Dow consists of a greater percentage of dividend-paying stocks.

But whatever type of investor you are, there is probably a more specialized index you can use to benchmark yourself.

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