Wednesday, October 28, 2009

What Does The Index Really Tell You?

We looked here at the Dow Jones Industrial Average, and saw why it's not a great measure of US stock performance, despite being a favourite index when it comes to media coverage. The S&P 500 is a much better barometer for the health of US stocks, though an understanding of its calculation methodology is important in order to understand the limits to its usefulness.

The S&P 500 is essentially a market-value weighted index*, meaning a company's influence on the index is proportional to its size. This much different than how the Dow Jones Industrial Average is calculated. Also unlike the Dow, the 500 stocks that comprise the index are chosen such that the index proportionally represents the economy's various industries. As such, the S&P 500 is not just the 500 largest companies. One interesting note is that despite being larger than almost every company in the index, Berkshire Hathaway is not a component of the S&P 500.

What does this mean for you? Basically if you invest in an index fund that mimics the S&P 500, most of your money is invested in the largest companies, thanks to the index's market-value weighting*. For example, the top 10 companies of the S&P 500 make up 20% of its value!

If you're a value investor like we are, and find more value in small companies than in large (for reasons discussed here), the S&P 500 neither looks like a good place to invest, nor does it provide a decent basis against which to compare one's returns, as it rises and falls with the largest companies.

While the S&P 500 is a useful indicator of the perceived health of the US economy, its usefulness as an investing and comparison tool is limited.

(*)Since 2005, this statement is only approximately true; Standard and Poors switched to only counting shares in its index that are available for public trading (as opposed to all outstanding shares).

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