Investing is an incredibly difficult pursuit. For most retail investors, going head to head with Wall Street pros and picking single stocks is, in the long run, a losing proposition. In light of this unfortunate truth, several famous stock market aficionados like Warren Buffett, John Bogle, and Jason Zweig have asserted that, for most individual investors, its best to just simply purchase large, diversified index funds. However, not all stock market indices are created equal. Rarely has that fact been made more clear than in 2020. The chart below shows the relative returns of the three major stock market indices commonly tracked in the U.S. (S&P 500, NASDAQ, DJIA) over the course of the past year:
As you can see, over the past twelve months there has been nothing close to parity in the relative performance of these three indices. In the same period that the NASDAQ is up 40%+, the DJIA is up a paltry 4%, meaning that investors who purchased shares of an DJIA tracking ETF like DIA have lost out on an additional 36% in gains.
There are two primary reasons for the divergent performance in the big stock market indices over the last 12 months. The first is that each index simply contains different companies and the second is that each index is weighted differently.
For example, the S&P 500 contains 500 large U.S. companies across a variety of industries and is weighted according to market capitalization. This means that as a company's market capitalization (i.e. Share Price x Shares Outstanding) increases relative to the aggregate market capitalization of all the companies in the index, the more that company's performance will impact the value of the index. In practice, this means that because the ten largest companies in the S&P 500 account for over 25% of the market capitalization of the entire index, those ten companies have a correspondingly outsized effect on the performance of the index.
The NASDAQ composite index, on the other hand tracks the performance of all ~3,300 of the companies listed on the NASDAQ stock exchange. Crucially, the NASDAQ composite as a whole is heavily comprised of companies in the information technology sector, and as we all know, tech has been a big and profitable business over the last 15 years. Invesco's QQQ index tracks the 100 largest non-financial companies listed on the NASDAQ exchange, which collectively account for ~90% of the performance of the overall NASDAQ composite. Like the S&P 500, the NASDAQ is weighted by market capitalization, but because the index is so heavily made up of high-growth technology businesses, it has soared over the last year as shares in that space have taken off (think Apple, Facebook, and Google). This factor explains the relative outperformance we see in the chart above.
Last but not least is the DJIA. The Dow Jones Industrial Average is the oldest stock market index in the U.S. and it is comprised of 30 large-cap companies that represent a large portion of American industry. These companies are household names like The Home Depot, Caterpillar Inc., and Goldman Sachs, and are commonly referred to as "blue chip" stocks due to their size and relatively steady, mature business models. Unlike its brethren, the DJIA is not weighted by market cap, but is weighted by the share price of the components included - this gives higher priced shares a larger impact on the index regardless of overall market capitalization. As the chart above illustrates, the blue-chip nature of the companies included in the DJIA have caused the index to be far outpaced by the S&P and the NASDAQ.
The takeaway here is that stock market indices are, in fact, very different from one another, and their differences drive significant divergence in performance over time. Depending on the macroeconomic environment, investing goals, and timeline, its best to think through which index is right for you before following Warren Buffett's advice.