Chances are when you visit the doctor for a physical checkup, you go to a general practitioner.  You probably wouldn’t go to an ear, nose, and throat specialist.  Although the latter would have more expertise in those particular organs, it’s the broad view of your body that you’re looking to understand.

Why isn’t it the same with the stock market?  Tune in to any news channel on TV or pick up any newspaper and the one U.S. stock market benchmark that you will inevitably find reported is the Dow.  Yet the Dow – or more formally the Dow-Jones Industrial Average (DJIA) – is not especially representative of the market.  Or for that matter of industrial stocks.  So why has the Dow become so ubiquitous?

The answer might be that the Dow is simply the older index.  It was created by Dow Jones & Co. co-founder Charles Dow in 1896.  That’s a pretty long-lived track record.  Unfortunately, it’s hard to use the Dow to measure long-term performance for several reasons:

• The 30 stocks comprising the Dow – not a very representative sample out of about 3000 publicly-traded U.S. companies – are chosen periodically by a selection committee at Standard & Poor Dow Jones Indices, currently a unit of McGraw-Hill Financial. The criteria by which they are selected is not publicly disclosed to my knowledge.
• The composition of the DJIA is constantly changing. In fact, it didn’t even start with thirty stocks.  The original index comprised only twelve.  It wasn’t until 1928 that it grew to its current size.
• With different companies moving in and out of the index over time, it lacks the consistency to use as a gauge of performance over its history. In fact, the only company to consistently remain on the index from its inception is General Electric.

As if that weren’t enough, there’s a bigger problem with the Dow, and that is how it’s calculated.  It is a price-weighted average, which means the higher the stock price of a company in the index, the bigger the impact of its price movements on the overall index average.  Even a company stock split (which actually has no impact on the company’s valuation) would cause the Dow to fluctuate.  I can think of no rational reason for this approach other than possibly the ease of calculation during all those years without computers being readily available.

The S&P 500, created in 1957 as an alternative index, is a market capitalization-weighted index, meaning the weighting of the funds in the index is based on the stock price times the number of shares outstanding.  This is logically a better measure of value.  And with 500 stocks in the index, it is certainly more representative of the broader market.  It also utilizes objective criteria by which a company can join or exit the index.

Or you could go the full general practitioner route and choose the Russell 3000.  It measures the performance of the 3,000 largest publicly held companies in the U.S. as measured by total market capitalization (the same methodology used by the S&P 500), and represents approximately 98% of the American public equity market.

But at the end of the day, perhaps it really doesn’t matter.  My readers know that I do not recommend using any benchmark to determine how well your investment portfolio is performing.  What’s much more important is whether or not your investments are growing sufficiently to support what you want to do for the rest of your life.  So my advice would be to eschew all such benchmarks and concentrate instead on the appropriate balance of investment risk and return needed to meet your future goals.  You’ll find that your checkup visits with your doctor will become much less stressful.