How the financial indices relate to your financial plan
Hi everyone! Welcome back to Melissa Making Cents!
As a CERTIFIED FINANCIAL PLANNER™, I have always had a certain apprehension about sharing what I do. It seems to me you are either the life of the party, or avoided like the plague, depending on what is happening in the financial markets.
2020 has been a wild ride. This is especially true for the stock market, where financial indices like the S&P 500 dropped precipitously at the end of March before approaching pre-COVID levels again by October. And no one knows what they’ll look like by the end of the year!
While financial indices can be a good indication of how the stock market is performing, that doesn’t necessarily mean that an individual’s investments follow the exact same pattern. In fact, I’ve started getting calls from clients who see news that the Dow Jones and S&P 500 have hit new highs. They then ask why their accounts are not performing as well.
The indices are nice to look at, but I do not believe they are an accurate representation of most portfolios, other financial professionals may not share my belief. Contrary to popular belief, most portfolios do not mirror the indices 100% because clients vary in their risk tolerance and investment goals. Today I’ll share a brief overview of the two main financial indices -- the Dow Jones Industrial Average and S&P 500 -- and how they relate to your financial plan.
There are over 3.3 million financial indices worldwide!
Yes... you read that right! According to The Financial Times, there are 3.3 million different financial indices worldwide. The article goes on to say that in 2018 there were only 43,192 publicly traded companies worldwide. This means there was roughly 70 indices for each of the 43,192 public companies.
In the United States, there are 5,000 indices alone, yet we put most weight on the Dow Jones industrial Average, the S&P Index, and the Nasdaq Composite Index.
The Nasdaq Composite Index is the smallest of the 3 commonly used US Indices.
The "over the counter" Nasdaq Index is named for the National Association of Securities Dealers Automated Quotations exchange, which was the first exchange that allowed for speedy electronic trading of stocks. Unlike the Dow Jones and S&P indices, the Nasdaq index tracks 2,500 holdings. It accounts for common stocks, real estate investment trusts (REITS), limited partnership interests, and American Depositary Receipts (which are foreign holdings traded on the US exchanges).
The Nasdaq Composite Index uses an company weighting to measure it's performance. As of March 15, 2020 it is compromised of 48% technology, 19% consumer services, 10% health care, 7% financials, 6% industrials, 5% consumer goods, and the remaining 5% is divided unequally into utilities, telecommunication, oil and gas and other materials.
The Dow Jones Industrial Average (DJIA) and S&P Index (S&P 500) are financial indices that track the stock performance of a sampling of the largest publicly traded companies.
Two of the best-known financial indices are the Dow Jones Industrial Average (DJIA) and the S&P 500. More specifically, the Dow Jones Industrial Average tracks the stock performance of 30 large U.S. companies. You might hear the term “blue-chip” associated with the stocks within the DJIA index. This refers to the fact that the DJIA only includes well-established companies that tend to be reliable in their earnings and dividends. While investors cannot directly purchase shares in the Dow, it is possible to buy an exchange-traded fund (ETF) composed of these 30 stocks.
Similarly, the S&P 500 tracks the performance of 500 large U.S. public companies, representing about 75% of all publicly traded stocks (by market value). As with the Dow, investors can purchase index funds or ETFs that hold shares from these 500 companies and track the index. Index funds in the S&P 500 are known for carrying low fees and offer a relatively easy entry to investing.
Another important thing to note is that even though both of these indices represent many companies, the companies are not equally represented. The S&P 500 uses a market capitalization weighting method, which means companies with larger market capitalizations account for a higher percentage of the index. By contrast, the DJIA is a price-weighted index, which means that companies with higher stock prices account for a greater percentage of the index. This leads to one of the main challenges of using a financial index as a measure of the market health...
Because the main financial indices are not equally weighted, the top 7 holdings can skew the index returns.
As you may have guessed by now, the financial world LOVES acronyms. The top 7 holdings in the S&P Index are also called FAANGM stocks (Facebook, Apple, Amazon, Netflix, Google, Microsoft). And the performance of these stocks can have an outsized influence on the overall index. According to Credit Suisse, the stocks of Apple, Amazon, Alphabet (Google’s parent company), Microsoft and Facebook rose 37 percent in the first seven months of 2020. But at the same time, all the other stocks in the S&P 500 fell a combined 6 percent. So looking at these indices might instead be a better view of how the largest of the large companies (especially in technology) are performing, without providing a more holistic view of the market or other industries.
A well-balanced portfolio should include more assets than only funds from the S&P 500 and the DJIA.
So back to that initial question of why an individual portfolio’s performance may not exactly match the trends you see for the S&P or the DJIA. Well, diversification is the name of the game when it comes to investing. The S&P 500 and the DJIA only represent large public companies in the U.S. But your portfolio may include other types of investments such as bonds, individual stocks from smaller U.S. companies, and foreign stocks. You may also have a lower risk tolerance, especially if you are approaching retirement, and prefer to invest in bonds or “blue-chip” stocks rather than a broader swath of companies.
Diversifying your portfolio means that you won’t be as sensitive to the highs -- or the lows -- of the market. Instead, diversified investing is designed to offer greater financial stability over a period of time to help you reach your long-term goals.
A financial planner can help you create a financial plan.
As a CERTIFIED FINANCIAL PLANNER™, I help clients create investment portfolios tailored to their risk tolerance and overall financial goals. I’ve worked with clients who are entirely new to investing, as well as those who are more seasoned pros looking for a second opinion. If you are interested in guidance in developing your own portfolio or financial plan, please call or email to schedule an appointment with me.
Until next time...this is Melissa Making Cents!
Melissa Anne Cox CERTIFIED FINANCIAL PLANNER™ is also a College Planning and Student Loan Advisor, and Financial Coach in Dallas, Texas.