Why You Shouldn't Follow the Dow

Its 30 stocks don’t say much about the broad market.

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Many people follow the action of the Dow Jones Industrial Average (DJIA) to get a feel for how well the market is doing. Nary a day goes by without the top national news anchors mentioning how well this venerable index performed on the evening news.

What is it?

Created by Charles Dow in 1896, the index measures the performance of 30 large, publicly owned companies. It is price-weighted, which means that the company with the highest price per share carries the most weight in calculating the daily index value, while the company with the lowest price per share carries the least weight. In other words, the index is more influenced by the performance of, say, IBM with the highest price per share (trading up around $135) than it is by Alcoa with the lowest price per share (trading down around $12). The 30 stocks are also large capitalization stocks, meaning the companies are valued in excess of $10 billion.

Who cares?

Investors who have a complete and comprehensive financial plan should not have to worry about the daily Dow performance because they will likely have an investment strategy that includes investments in companies that are small- and mid-capitalization, ranging from around $300 million in value up to $10 billion. Additionally, these investors hopefully own more than just 30 stocks.

What's better?

For the investor with a portfolio diversified across numerous large-, mid-, and small-capitalization stocks, the more appropriate index to follow is the Standard & Poor's 500 Index. It's worth noting that the S&P 500 index is not made of the largest 500 corporations in the United States. Rather, the S&P 500's smallest market cap stock comes in at $1 billion and its largest measures in at around $290 billion. This index reflects the performance of 500 stocks versus 30 and it has much more depth than the Dow Jones. As a result, the S&P 500 is more representative of how an investor's portfolio should look. While it does not capture a lot of small capitalization stocks, it has more than the DJIA, making the S&P 500 a much better barometer for the individual investor.

The 10 sectors

In addition to the different market capitalizations, the S&P 500 also reflects 10 general sectors of the U.S. economy. Here's a quick guide:

1. Consumer Discretionary: companies that are sensitive to changes in the economy—producing goods people want—such as autos, household goods, apparel, and leisure goods such as hotels and restaurants.

2. Consumer Staples: companies that are less sensitive to changes in the economy—goods people need—such as food, tobacco, beverage, and personal product producers.

3. Energy: companies that build drilling equipment or other related goods and services along with companies that conduct exploration and productions of oil and gas products.

4. Financials: companies that transact in a financial specialty such as general banking, mortgages, credit cards, and other consumer finance functions, insurance, investment banking and asset management, real estate/REITs, and corporate finance.

5. Healthcare: companies that manufacture both healthcare equipment and supplies, provide healthcare services, and conduct research, development, and production of pharmaceuticals and biotechnology products.

6. Industrials: companies that manufacture capital goods and industrial machinery, provide transportation and transportation-related equipment, and create infrastructure.

7. Info Tech: companies classified as technology software and service providers, technology hardware and equipment manufacturers, and semiconductor and semiconductor equipment manufacturers.

8. Materials: companies that deal with commodity-related mining and manufacturing materials such as metals, glass, paper, construction materials, and chemicals.

9. Telecom: companies that provide communications services through landline, cellular/ wireless, and fiber optic cable.

10. Utilities: companies that are producers and/or distributors of power or that provide gas, water, and electric services generated from conventional or nuclear power plants.

While the Dow is the oldest and the most widely recognized stock market index in the world, it is not the most appropriate index to use as a benchmark for an individual investor's portfolio. Following the performance of the S&P 500 index will allow the diversified investor to have a deeper understanding of how well the overall market is doing.

Following 30 big companies is interesting, but keep in mind that it does not reflect everything going on in the stock market.

David B. Armstrong CFA, is a Managing Director and co-founder of Monument Wealth Management in Alexandria VA, a full service Private Wealth Planning and wealth management firm. Monument Wealth Management is backed by LPL Financial, the independent broker-dealer. He has been named one of America's Top 100 Financial Advisors for two straight years by Registered Rep Magazine (2009 & 2010). David and Monument Wealth Management can be followed on their blog at "Off The Wall", their Twitter account @MonumentWealth, and on their Facebook page. Member FINRA/SIPC. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial advisor prior to investing. All performance references is historical and is not guarantee of future results. DJIA and S&P 500 are unmanaged indexes and cannot be invested into directly. Securities and financial planning offered through LPL Financial, Member FINRA/SIPC.