Sent March 2022
When people talk about doing better or worse in something, the term itself connotes that there must be something that you are comparing it against. In athletics, keeping score (speed, height, points) is the metric and so that’s pretty clear. But then there’s the insightful quip from social satirist H.L. Mencken that “a wealthy man is one who earns $100 more a year than his brother-in-law”, a comment which introduces the whole notion of comparative, but totally subjective, assessments.
On investments, we commonly use benchmarks of how the “market is doing” to get a semblance of whether we are doing better or worse in our portfolio. However, it might be instructive to understand how those financial benchmarks are actually created and I dedicate this letter to educating you on this important subject.
An Overview Of Investment Benchmarks
In the world of investments, there are easily 100 ‘benchmarks’ or indices that exist (a market index is a certain type of benchmark). For stocks, or USA the stock market in general, there are three benchmarks that we regularly hear quoted or referenced daily if not minute-by-minute; These are The “Dow Industrial Average”, the “S&P500”, and the “NASDAQ.”
To make you far smarter than the average bear, let me briefly explain what each of these animals may be:
The Dow
“The Dow,” or more fully the Dow Jones Industrial Average, is representative whether the market is going up or down. However, in spite of the fact that there are roughly 4,000[i] publicly traded companies in the United States, most people do not realize the Dow is comprised of only 30 companies (less than 0.1% of all firms). Nonetheless, these 30 entities are commonly called ‘Blue Chip’ companies that are viewed as representing the cross section of American business.
Some other tidbits on the Dow:
- It is the oldest benchmark of the 3 mentioned, founded in the year 1896 by Charles Dow and his associate Edward Jones.
- Originally, there were only 12 companies in it — and it represented more of what the USA was then, with the Average being dominated by tobacco, sugar, leather and railroad companies (it’s too esoteric to describe here but the “Dow Divisor” is now 0.14748071991788 so new companies can be added in without jilting the Average)
- A private committee votes companies in or out, and in 2018 Walgreens booted long-time stalwart General Electric (GE) out of the Average and you might recall the hoopla of Tesla being added in December 2021
- Of biggest note…The Dow doesn’t measure the size of the company, or its ‘market capitalization’, but strangely it is just an average of 30 stock prices. Thus, a company with a higher stock price counts for more in the average than does a company with a lower stock price. At the time of this writing, the medical insurer UnitedHealth constitutes 9.17% of the average ($467.81 per share) and chip manufacturer Intel counts for only 0.91% ($45.04 per share).
The S&P500
The “S&P500” is just what it sounds like; a basket of the 500 of the largest companies traded either on the New York Stock Exchange or NASDAQ. It’s a ‘market cap free-float weighted’ index (market capitalization being computed as the share price times the number of shares outstanding).
Some tidbits:
- The Standard and Poor’s organization introduced the S&P500 in 1957, though it’s genesis goes back to 1923 when there were only 233 companies in it
- Because it’s a market cap weighted benchmark, the MAAMA’s (Microsoft, Apple, Alphabet, Meta ((formerly Facebook) and Amazon) are 5 companies (1%) that make up roughly 20%[ii] of the value of the S&P500
- The 500 companies might collectively be 10-15% of the total number of traded companies, but they commonly represent 70%[iii] or more of the total USA stock market capitalization
The NASDAQ
Finally, considered the ‘little guy’ index, because The National Association Of Securities Dealers Automated Quotations (NASDAQ) was originally the system that replaced hand-to-hand Over The Counter (OTC) exchanges of stock occurring between dealers.
Some tidbits on it:
- The NASDAQ Composite Index wasn’t started as ‘exchange’ but frankly only to publish quotes…though it initially only published quotes on 50 companies, not the 3,000 that are there now.
- The NASDAQ was initially established by a regulatory body (FINRA, and its forerunner NASD) until it was sold.
- Its real claim to fame is that it was the first entirely electronic stock market system
- Due to fact technology companies dominated the NASDAQ and technology was ‘new,’ it was initially referred to as the “smallcap market,” but now with Apple, Microsoft, Cisco, Oracle on the exchange that term no longer gets used.
- The NASDAQ is very competitive against the NYSE, and some notable companies have switched to it such as PepsiCo and Kraft Heinz.
What Benchmarks Mean For You
All of the above is to calmly point out that when people try to see how their portfolio did versus ‘the market indices’ they have to keep in mind what they are comparing. A straight index (like the S&P500 index) should absolutely follow the S&P500 benchmark (though truth be known, most “500” funds only contain a representative sample of the 500). Our clients’ equities are NOT a straight index… which is also why they are down 2-3% less than the market is down in 2022. That’s also by design…but that’s a topic for a different day.
It remains my deep and distinct honor to serve you well.
Patrick Zumbusch
Founder and CEO
Wellspring Financial Partners
[i] “Total Stock Market Index Vs. S&P500 Index” (Kent Thune, TheBalance.com, November 21, 2021)
[ii] “Big 5 Tech Stocks Now Account For 23% Of The S&P500” (Andrew Bary, Barron’s, July 26, 2021)
[iii] “Total Stock Market Index Vs. S&P500 Index” (Kent Thune, TheBalance.com, November 21, 2021)
