The S&P 500 Index is near record highs. Does this matter more than new records on the Dow? Just a little more than one year ago, I commented on, what was at the time, a significant breakthrough. In a blog post, 13,000: Does the Dow Still Matter?, I said a few things that deserve revisiting now as the Dow Jones Industrial Average Index has surpassed 14,000 and set new record highs and the S&P 500 Index is close behind for a new record of its own. Here are a few choice excerpts from the post on February 22, 2012:
Why should investors really care what the Dow does?
The reason why investors should care is because investors care. This sounds a bit silly and redundant but investing is largely a herd activity. If an investor thinks the herd will like something, the investor may naturally have a bias toward that same thing...
To paraphrase John Maynard Keynes, it's not important to choose who you think is the prettiest girl but who the judges think is the prettiest girl.
In summary, the Dow hit 13,000 this week for a moment then fell because the crowd felt a bit intimidated by this new large number not seen in four years. Some investors question whether the Dow "still matters" anymore because it only represents 30 large US companies, whereas the S&P 500 Index represents approximately 500. The Dow does still matter because it is a psychological barometer -- it is something the crowd watches. Therefore the investor watches it.
The Dow is the pretty girl.
The S&P 500 is What the 'Smart Money' Watches
The Dow Jones may be "the pretty girl," but the S&P 500 is the prettiest and the smartest, only in figurative terms, of course! To escape from this metaphor trap, let's shift to something else--the so-called "smart money" crowd. The Dow Jones may get more headlines, because it is the best known among laypeople, but the S&P 500 holds more weight with experienced investors and traders because it is a more accurate reflection of "the market."
The reasoning is that, in addition to representing more than 500 companies, as compared to just 30 for the Dow, the S&P 500 is a "cap-weighted" index, whereas the Dow is a "price-weighed" index:
- Cap-weighted: Stocks in the S&P 500 Index are in order of highest market capitalization, which is value of a companies number of shares of stock outstanding multiplied by share price.
- Price-weighted: Stocks in the Dow Jones Industrial Average Index are selected by a committee of editors from the Wall Street Journal, which is owned by Dow Jones, and are in order of share price. The greater the share price, the greater the influence on the overall movement of the index.
Therefore, the S&P 500 is broader and cap-weighted, which makes it a good barometer for large-capitalization (large-cap) stocks in North America. The Dow can be a reasonable measuring stick in terms of reference to history but the "smart money" has its eye on the S&P 500. And thus traders, who use technical analysis, are more interested in its movements.
How about you? Long-term investors can simply invest in one of the best S&P 500 Index funds, forget about the news, and go on about their daily lives.