U.S. News and World Report: How does the S&P 500 and Nasdaq Composite differ from each other and the Dow Jones Industrial Average?
Dr. Chris Hughen: The DJIA is the Kim Kardashian of financial metrics. It is ever popular and educated people just wonder why. It was established in 1896 and represents the returns on just 30 stocks of large companies.
In contrast, the S&P 500 Index is the world’s most tracked benchmark. This is a key issue for investors as many financial products compete to replicate the returns on this Index. More competition means lower fees for investors. Some popular funds that track the S&P 500 Index only charge fees of 0.05% per year. It is the ultimate investment product – diversification at a low cost. The S&P 500 Index provides it exposure to about 80% of the stock market. This diversification provides low risk so people can invest and forget about it.
While the Nasdaq Composite provides exposure to over 2,500 stocks, it is not as diversified as the 500 Index. About half of the return on the Nasdaq Composite comes from technology companies, which represent a smaller portion of the U.S. economy.
Why do these differences matter?
The DJIA is price-weighted while the S&P 500 Index and Nasdaq Composite are market-capitalization weighted. Market-cap weighted indexes provide better diversification than a price-weighted index. It’s like comparing a horse & buggy to a Tesla. No surprise that the Dow started in 1896.
How do they choose companies?
The companies in the indexes are regularly reviewed to ensure certain levels of liquidity, diversification, and investability. Ultimately, these indexes are valuable brands that provide licensing fees to their creators. While it is not obvious to most people, the stocks in the indexes are chosen to maximize the brand’s value.
What types of potential overvaluation concerns should investors pay attention to, watch right now?
The Nasdaq Composite represents heavy exposure to pricy tech stocks, like Amazon, Facebook, and Alphabet. Investors have bid up the value of these stocks to represent their increased importance to American consumers. If they continue to dominate, their price is appropriate. However, history documents lots of fallen tech angels. IBM no longer makes laptops or mainframe computers, Blackberry lost its dominance of the phone market, Facebook crushed Myspace….
In short, almost all investors should focus on a low-cost, diversified investment strategy. Life is too short for most people to spend time on complicated investment strategies. The 500 Index is clearly superior to the DJIA or Nasdaq Composite.