Saturday, November 5, 2011

The Market

What do people mean when they talk about "the market?"  When they say the market is up 200 points, what exactly are they referring to?  If you hear this terminology, but never knew exactly what it referred to, this is the post to read.

The market most generally refers to the Dow Jones Industrial Average.  This is an index of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq.  It was initially created to guage the industrial sector of the American economy (hence the I in the DJIA), but its performance continues to be affected by broader economic impacts.  Currently, the DJIA holds many non-industrial stocks such as Bank of America, Johnson and Johnson, Verizon, and Wal-mart.  People watch how this basket of stocks performs to get a sense of how much stocks in general are moving, even if the index is not a good representation of all companies.

Another common index "the market" refers to is the Standard & Poor's 500.  More commonly abbreviated to the S&P 500, this index consists of 500 stocks chosen by market size, liquidity and industry group, selected to represent the risk-return payoff of large cap stocks as a whole.  Some stocks in the index include Alcoa, Boeing, Chevron, Starbucks, and Visa.

There are passive index funds that track these indices if you want to get some exposure to the general market in your portfolio.  In the long-run, stocks outperform any other asset class and the easiest way to get a diversified portfolio may be to just invest in "the market." A lot of individual stocks have a portion of their returns tied to the market (in other words, there is some correlation between market returns and that particular stock's return).  Individual stocks usually have some unique risk which may yield higher rewards, but they generally have a lot of non-systematic risk which can be diversified away by holding many stocks in a portfolio.

"The market" may not show everything that is happening in the economy, but it is usually a good representation of how investors are feeling about the stock market as a whole.  There are several other indices that may cover areas where the DJIA or S&P don't, such as the Russell 2000 index for small-cap stocks.  These benchmarks are what most portfolio managers compare themselves to on an annual basis, seeing if they have the skill to "beat the market."  Many, many managers, however, generally fail to return more money than the market and amateur investors even more so.  If stock picking is difficult for you but you want to get some exposure to the long-run return of the market, the easiest thing may be to just buy an index tracking the DJIA or S&P 500.

So far this year, both the DJIA and the S&P 500 are at about break-even.  If you watch the news, you will hear both bullish and bearish views.  In case I haven't mentioned it in previous posts, a bullish view means a positive view where people believe the stock market will go up while a bearish view is a negative view where people believe the stock market will go down.  I have heard people saying that this winter, the stock market should be rising because the savings rate has been dropping and people have been saving money on gas prices the past few months compared to earlier in the year.  In general, November to May sees a substantially larger increase in stock prices compared to June to October.  This is where the common saying, "Sell in May and go away," comes from.

Regardless if you invest in stocks or not, it is important to know how the market is doing since it often signals expectations for the future of the economy based on current news.  Now that you know what the market refers to, hopefully you can understand a bit better what people may be talking about when they throw this terminology around.  I will refer to the market in future posts as well as the S&P 500 but will specify if I mean the DJIA.

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