Is it Time to Rethink the Way We Look at Stock Indexes?

Stock indexes

Stock indexes are neither created equally nor are necessarily designed to be representative of stocks in general. People want them to be, but they need to wonder why.

Whenever we refer to how stocks in general or the stock market is doing, we refer to the performance of stock indexes, baskets of stocks assembled by the index to accomplish some particular goal.

The Dow Jones Industrial Average, for instance, has consisted of a changing group of what once was limited to industrial stocks and has expanded to contain a broader assortment of sectors. This is a good thing, given how poorly industrial stocks have done, but now they have pretty much everything in there, including a number of technology stocks, today’s leading sector.

Dow Jones has done a fine job of putting together an all-star team of companies that are very significant in their sector as well as having all significant sectors well represented. The index may be smaller than its competitors and therefore more subject to stock risk, like the way Boeing’s troubles have moved it so much, but they do a pretty good job nonetheless of being representative of large cap stocks in general.

This is also the goal of the S&P 500, which is these days even more widely followed than the Dow, and has been elevated to such a level that it is now considered to be “the market.” The Dow still gets quite a bit of press and attention though, and were once king but still are at the level of a prince.

One of the real differences between the S&P 500 and the Dow is the Dow actually accomplishes the goal of representing big cap stocks generally a lot better than the S&P 500 does, but the S&P 500 is actually built to trade more, which is what we use these indexes for mostly.

Indexes can provide us information, but they also give us a means of investing in these bundles of stocks, and these indexes are definitely invested in widely, especially the S&P 500. When people buy index funds, they mostly invest in the major indexes, where funds will then assemble them to mirror these indexes.

Funds therefore will manage their positions with the components of these funds according to how the particular index that they are tracking them proportions them. The way that an index manages this will therefore have an effect upon the sort of returns you can make. The S&P 500, by their system of favoring stocks rising in price, has an advantage over an index such as the Dow which isn’t quite set up to do this as well.

The S&P 500 and the Nasdaq are market cap weighted indexes, which has the effect of favoring better performing stocks over lesser performers. As a stock goes up, its proportion of the index increases, and when it goes down, it represents a lesser proportion. They start out by weighing the bigger stocks more, and as all stocks grow, the bigger they become, the more impactful they are.

Market cap weighted indexes can have a few stocks comprising a large percentage of it, and you hear things like a big part of a move over time has been driven by these big stocks. The Dow, on the other hand, uses price to weigh its stocks, and price is less connected to performance then market cap. Prices vary widely actually, and only the most uninformed would ever think that you can make good judgements about stocks merely based upon price.

You can look at the weighting of Dow components just by looking at their price, with Apple being worth several times more than the ones with smaller prices, and based upon this higher weighting, a given percentage increase will affect the Dow a lot more than moves in these more modestly priced stocks. However, the problem is that higher price and potential to grow doesn’t fit all that well normally, even though Apple has both.

Market capitalization, on the other hand, isn’t just better correlated with performance, it can cut out a much bigger piece for the bigger companies. The missing piece with price weighted indexes is the number of shares a company has out there, which it ignores but market cap weighted indexes account for.

Few investors indeed are aware of this phenomenon, and although this isn’t that big of a deal, it’s still important to know what we’re buying when we invest in index funds, and what we are buying isn’t just a basket of the stocks that are in our indexes, the way that the individual stocks in our basket are weighted, how much of each of them we actually bought, at least needs to matter.

People basically buy the bag though and don’t even open it, either to look at how much of each stock are in it or even whether or not this bundle is a good one. It’s the Dow, or the S&P 500, and that’s enough, and we are then entitled to take this and run with it and not discriminate further.

Why We Would Want Broad Representation is a Question We Need to Ask

Regardless of how representative our basket is of the “stock market,” the idea of this being what we want is pretty clear, but why we would want such a thing is left at the door when we buy these indexes. It is one thing for these indexes to provide information to the public that seeks to provide them with benchmarks that can be used as proxies for the performance of U.S. stocks overall, but this doesn’t mean that we should want to own and trade such a basket of stocks over looking to actually decide what we should be holding based upon more meaningful and pertinent criteria.

The strategy behind broad index investing approaches stocks as if they were random and unpredictable, and you even hear people tell you that you want to have all these stocks in your basket because you never know which ones will have a good year and owning all of the stocks in an index will ensure you don’t miss out on anything.

Stock movements aren’t random though so this idea isn’t grounded in truth, and we should know that stocks perform differently and in ways that are discernable. We may desire exposure to all the different types of stocks out there in all the different sectors that we can invest in, but we should never just invest blindly and these decisions deserve at least a little thought considering our money is on the line with these bets.

The new landscape of stocks has moved away from being able to comfortably invest in these broad indexes as stocks aren’t going up together in the same way that they used to. This is especially the case in 2020 where the market has had its cradle rocked pretty hard and this has resulted in the differential between the have sectors and the have-not sectors widen even further, even though this has been a trend that has been building for some time.

We can see this unfold right before our eyes when we compare the performance of these broader indexes with the Nasdaq, which is much more focused on the technology sector and have benefited more from the better growth that this sector has enjoyed over the last few years.

We can just look at year to date performance of these three major indexes to see how all of this is playing out today. The Dow is down 8.9% for the year, and while it has spread the divergence between sectors around pretty well, the stocks that have suffered are in the majority. The S&P 500 has had its hotter stocks step up more to make up for the laggards, and while that is reflected in its only being down 1.8% versus the Dow’s 8.9%, it’s still down money.

The Dow is indeed more representative of big cap stocks in general, but that’s no consolation when this only gives you poorer performance. You might want to have a desire to strive for the mediocre, but we need to at least be aware that this is what we seek when we prefer lower returns like this just to get our money spread around more.

The Nasdaq 100, on the other hand, has the advantage of having better performing stocks in it, not just this year but for many years now, with their advantage over a more balanced selection increasing over this time. The Nasdaq 100 isn’t down for the year, it’s instead up by 23.1% so far, beating the daylights out of their big brothers.

Having a wide exposure to different sectors has been far from a benefit and has actually been a big millstone around the necks of these two other indexes. It is not that this divergence has not been foreseeable, as we’ve been promoting the Nasdaq over these other two for years, and end up continuing to be right about this. This is no great feat though and all it takes is to pay attention a little but a little is beyond the threshold of most investors.

This is not about one index being better than another as much as it is about investors needing to rethink their seeking balance and just end up balancing themselves far too much toward seeking underperformance to weigh down their portfolios, and the example with the Nasdaq just serves as one example of what happens when we mess our portfolios up with this sort of thinking.

Just Believing Without Thinking is the Real Problem Here

The big reason why this continues to happen, even though it is no secret to investors that it goes on, is that they insist on clinging to their old ideas in spite of any evidence against them. They hear how hot the tech sector is and even though going with that sector more would mean the difference between a very good year so far, and 20% in a year is enough to titillate these investors, they instead are happy to settle having a poor year where they have fallen behind on a net basis instead of moved ahead by this nice amount.

They fear that if they weigh one sector so much and the sector suffers, they may be left in a considerably worse position, and instead choose what they believe to be a safer route. They misunderstand that the tactic of leaning more heavily on a hot sector isn’t the strategy itself, it’s part of the bigger strategy of going with what is working, which just happens to be the tech sector now but could be any sector that is proving its worth this way, showing that it is so much better.

It turns out though that the technology sector has several major advantages over other sectors. It’s always better to have strong reasons to support the better performance that you see from a sector, as this allows us to be more confident that these trends will continue in the future.

We benefit when the companies that we buy stock in grow more, and we also benefit when their stock grows more as well, and these aren’t quite the same thing. Company growth is actual growth, seeing both their current numbers and the ones in the near term continue to go up. Stock growth accounts for both this growth and the potential for future growth.

The same thing applies when we look at sectors, like the technology sector versus the industrial sector. The industrial sector depends on people spending more money each year on these things, which has grown but at a slower level than the economy as a whole. People make more money over time but they spend a greater proportion on other things such as technology, and especially on technology, which therefore grows faster than the economy.

As we have just seen, technology stocks can also do well when spending is reduced, and even when a lot of them lose their jobs and are stuck at home. Technology has prospered during the lockdowns and this is a big reason why they have outperformed the average stock so much this year, although they do this in the good years as well. We’re gravitating toward spending more and more on it, and the value of these stocks keep expanding as this continues.

Another harmful idea that is widely held that holds back investors a lot is the one that the better a stock does, the more we need to be afraid of it. This does not make any sense and runs counter to what really happens, but myths can be pretty influential as long as people just continue to believe them.

If you buy the S&P 500 or the Dow, you don’t have to think about such things, you don’t have to think about anything if you don’t want to, and people generally do not want to do any. You just put a certain amount in these things every pay and get what you get in the end. You may get upset when things don’t go your way the way you want, but you blame external factors for this lack and refuse to look in the mirror or even consider that you may be responsible yourself for this due to making poor choices that you haven’t even bothered examining.

Investing in a broad index isn’t choiceless like many would prefer to look at it as, as it involves the same mechanism of choice as any other investment decision, choosing these baskets of stocks over all the other things you could be putting your money in.

People are masters of their own kingdoms, even if all the power they exercise is turning over the decision making to the most mindless of approaches, because they are the ones that ultimately choose to be mindless. They don’t even trust these indexes enough to put all their money in them as they will choose to dilute the muted returns that they provide further by putting half of their money in even lower performing assets like bonds.

This needs some serious rethinking as well, as if we dare to do the math with this dilutive approach, its inferiority becomes very evident. People don’t do the math though, not just investors but no one in the industry that they are relying on for guidance either, and instead rely on old saws that are very easily shown to be quite mistaken under examination.

Investing very much remains in the stone ages, at the level of grunting, and our advisors grunt out a given approach to portfolio management based upon a time before our species obtained the ability to reason at a high level, and we grunt along in agreement, with neither of us willing to use much of the intellectual capacity that nature has given us.

We at least owe it to ourselves to think a little bit more about what we are doing than we do, as we’ll never get from under the thumb of being guided by misinformation if we cannot or are unwilling to tell the difference between good and bad information.

Like any scientific study, this all starts with a hypothesis, in this case how we might have fared under different strategies, rather than to try to pretend that they don’t exist our just assume ours is better without even bothering to check.

Rather than continuing to worship ideas such as sector balance or asset balance in our portfolios, we at least should start wondering about such things, and wondering is the necessary first step that so few investors even get to. It’s really time to start wondering now as the costs of not doing so continue to climb.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: eric@marketreview.com

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