I am sure everyone has heard of The Dow, S&P 500 and Nasdaq. Have you also wondered how do you look at these (and others) and get a snapshot of “what is going on.” I’ll use an example of apples and orchards to illustrate stocks and markets.
The DOW is the most well known. Why? It’s the oldest. It’s 30 stocks that are intended to be representative of the stock market.
Professionals don’t use it much. Why? Well, a few reasons: at 30 stocks you get don’t an idea of the broad market. It’s like picking 30 trees in an orchard to represent the whole orchard. If one tree is giving more bad apples it skews your understanding of the whole orchard, a lot more than say if you picked 500 trees and looked at all their apples. You might say – wow a lot of apples are going rotten. It might just be that one tree but it’s 1 out of 30 instead of 1 out of 500.
For the most part, it works. But if someone is always commenting on the Dow, odds are they’re pretty novice or just casual investor.
S&P 500 is basically like taking the 500 largest trees in your orchard. These are hardy and not likely to just succumb to small ebbs and flows of pests and health and such, so you can get a really nice feel for the health of your orchard. Unlike the Dow, you get a much bigger slice of your orchard – 500 trees instead of 30! So you have less chance of having a really skewed understanding based on one bad tree. Also, this only tells you what is happening with big trees in your orchard. It doesn’t tell you what is happening to apples around the world (maybe there’s a new pest abroad or some disease to Apple trees – you wouldn’t know that only looking in your orchard).
The S&P 500 tells you what large stocks are doing in the US market. It does not tell you much about everything else (small, mid, large, specific sectors, anything in any other country, bonds – you get the idea. Only stocks. Only big ones. Only the US).
Professionals look at a variety of indexes to get a “feel” for what’s going on – but if they had to pick one, the S&P 500 could be a worthy candidate.
NASDAQ is a bit different. It has both big trees and little trees. It’s kind of like tracking all the varieties of apple trees that came from one nursery. This NASDAQ nursery happens to sell a bit more fast growing Galas and Pink Lady’s. It doesn’t sell many Fuji’s. These trees grow quickly and have a beautiful bounty, but sometimes they die before they get to that point. But in your orchard it also kind of represents the broad orchard. With a slight more detail on those Galas and Pink Lady’s. So if those have more pronounced results during harvest, you’re going to see that more.
The NASDAQ holds large and small US stocks. It tends to be more exposed to Technology and Consumer discretionary sectors. It has negligible representation of the financial sector.
If you look at the NASDAQ, you kind of think – this is broad market looks like if I’m really wanting more detail on tech.
So as a summary, you see these are just ways of measuring things. If you follow them you can see trends to get an idea of what different parts or the market are doing. There are other indexes you can follow that will give you a better idea on other parts of the market.
Want a good representation of your WHOLE orchard? Take a look at the Russell 3000. Not 30, not 500 – 3000 trees! That’s basically the whole orchard.
Maybe you just want to know how your smaller trees are faring because you happen to have a lot of small trees and want to know if it’s a good time to plant more. Now these are smaller so there’s more of them. They’re also young, so the good ones will grow and some just won’t make it. The growth happens quickly and so does the disease. You have to rotate your trees a lot because these go in and out. If you want to track these more numerous, smaller trees? Well you should look at the Russell 2000.
Maybe you want to track the transition between small and large – and just look at those medium sized trees to get an idea how things are growing after they’ve gotten established, but not quite so big that they are super-hardy and impervious to decay (for the most part). Look at the S&P 400. Mid-cap companies.
Further, if you want to truly understand how apples are growing around the world, and be a great Apple farmer you should not only look at your orchard. Look at what’s happening around the world. Many farmers have gone through what you have, maybe somethings coming – good or bad – you can get a better idea of the bit world or apples this way. Check out (mostly) European apples (EAFE) or apples growing in up-and-coming agricultural areas abroad (Emerging Markets).
So you look at all these. So what?
Well, you’ll find sometimes everything looks the same. And sometimes everything looks different. That unfortunate pest you and all your farmer friends have been lamenting? Well it turns out our European friends are just getting over it. Maybe light at the end of the tunnel. Better buy more trees while they’re cheap since nobody’s buying.
Sometimes the S&P 500 makes everything look really good. Oh look all my apples are doing great! Then you look at the Russell 2000 and realize smaller trees are REALLY struggling. Hmm. Let me hold off on planting those and wait to do some soil tests before I waste more money on these dying small trees.
Or maybe it’s summer and those fast growing NASDAQ seeds are really doing well! Well your hardy trees are struggling. If you only looked at the big trees (S&P 500) you might have missed an opportunity!!
The more you know the better decision you might make with that better vision of each kind of tree group you’re looking at. In the end each harvest is unpredictable but at least you can be more educated so you can make adjustments more quickly (or even avoid overreacting) with that extra knowledge