Investment Consult

A better way to take the stock market's pulse

By Lewis J. Altfest PhD, CFA, CFP

Most investors use the Dow Industrials or the S&P 500to follow Wall Street's ups and downs. But a lesser-known index is better.

A new client of mine, a 55-year-old pediatrician, askedme whether she'd have enough money to retire at age 60. She handed me asheet of paper that listed her entire portfolio: $1.85 million in a singlemutual fund, Vanguard Index 500.

"This is highly unusual," I said, trying to hidemy surprise. "Don't you have any other equity investments?"

"No," she replied. "I don't have the timeor the interest to choose stuff on my own. I'm perfectly happy with averagemarket performance."

The truth is, she wasn't getting that, because the Vanguardfund she owned tracks the Standard & Poor's 500 Stock Index, which doesonly a fair job of mirroring the US stock market. The Dow Jones IndustrialAverage, the other major index that many investors say they're happy totrack, also has flaws. Here's what's wrong with those indexes--plus someinformation on an alternative that I believe does a better job of matchingthe overall US stock market.

The index you're most likely to hear about on the eveningnews--the Dow Jones Industrial Average--holds a mere 30 stocks, all of themlarge companies. But it has a bigger flaw, in my opinion: As a price-weightedindex, it's too easily affected by expensive stocks. On a typical day, achange in a $100 stock has twice the effect on the index as the same changein a $50 stock, and four times that of a $25 stock. For instance, even thoughAmerican Express and Walt Disney are about the same size, American Express,by virtue of its much higher share price, makes up 6.5 percent of the Dow'sweighting, as opposed to Disney's 1.3 percent.

The S&P 500 is a somewhat more reliable economic indicatorthan the Dow, because it includes many more companies, and not just bigones. In addition to giants like Microsoft, General Motors, and Gillette,you'll find in the index such relatively small firms as Albertson's, a retailfood and drug chain, and Vulcan Materials, which produces crushed stoneand paving materials, among other things. The S&P's Index Committeeselects the stocks, which are intended to represent leading companies inmajor industries--and, by extension, the entire US stock market.

However, like the Dow, the S&P 500 is a weighted index--inthis case, each company's weighting in the index is based on its total marketvalue. As such, the largest stocks in the S&P 500 tend to influencethat index most. Last year, for example, 30 large-cap growth stocks accountedfor nearly two-thirds of the index's total return of 28.6 percent, accordingto Smart Money magazine.

Both the Dow and S&P 500, then, emphasize big companies.That's great if you're trying to track the economy, because big companiesdo impact it most. But you're probably less interested in tracking the economythan in following the segments of the stock market represented in your portfolio.And that's likely a different matter, since your portfolio is--or shouldbe--well diversified among large-caps, mid-caps, and small-caps, value andgrowth stocks.

Like many other investment professionals, I think the ValueLine Index, which receives far less attention than the Dow or S&P 500,best reflects all of these markets. What makes the Value Line Index so special?It's unweighted, so all 1,700 of its companies are considered equally, withoutregard for their size or stock prices. Therefore, the largest company inthe index can have no more influence than the smallest.

That's important, because it gives you a truer pictureof what's going on in the market. Last year, for instance, the Value LineIndex finished the year up about 6 percent. That reflects the difficulttimes many small and medium-size companies were having relative to theirlarger brethren. However, based on the total returns for the S&P 500and the Dow in 1998, you'd assume that stocks of all types and sizes ofcompanies had a great year.

To more easily understand the concepts of weighted andunweighted indexes, think in terms of senators and representatives. Eachstate, regardless of its population, elects two senators. That's an unweighted,unbiased approach. The number of representatives, on the other hand, isdetermined by how many people live in each state. The states with the biggestpopulations get to send the most representatives to Washington.

Like the US House of Representatives, weighted indexessuch as the Dow and the S&P 500 have their place. Both will give youan idea of the economy's health. But they won't provide a clear pictureof how the stock market is doing overall--which is precisely what you andyour adviser need to allocate your money properly. *

Lewis Altfest. Investment Consult : A better way to take the stock market's pulse. Medical Economics 1999;19:46.