When most people talk about the market, they are likely referring to the Dow Jones industrial average, the index most commonly cited when describing stock market movements.
The oldest major index, the Dow dates back to the mid-1880s, when it tracked 12 stocks. It began tracking 30 in the 1920s, the same number it tracks today.
That might have been adequate almost 100 years ago, but in 2015 there were more than 4,000 publicly traded companies in the U.S. and more than 40,000 worldwide. So following the Dow in isolation might give you a view of stock performance that is inconsistent with the broader reality.
Take Oct. 26, when the Dow closed with a gain of 30.06 points. What does this tell you about stock performance that day? Probably a bit more up than down, right?
You would be wrong. Nearly twice as many stocks fell as rose that day, according to data from Yahoo Finance. Other big indexes were down.
The Dow is the only major index that is price-weighted. The higher the underlying stock’s price, the more it moves the Dow.
For example, Goldman Sachs, trading at around $178 per share, counts for around 6.7 percent of the movement of the Dow. However, its market cap — the value placed on it by public-market investors — is $73 billion, or only 1.3 percent of the collective market cap of the 30 companies.
A company’s market cap is a much better way to weight the components of an index. The companies with the largest market cap typically have a greater influence on the movement of stocks across multiple indexes.
Admittedly, there’s no perfect index. The widely quoted S&P 500 is focused only on the largest U.S. companies, neglecting the majority. The Nasdaq overrepresents technology companies.
That is why you can’t measure your portfolio based on any one index. If you want to do so, compose a benchmark comparison that is representative of your target allocation, including a large cap U.S. index, a small cap index and an international index; a bond index for your bonds; and an index for any additional asset classes that you hold in your portfolio.
That is more of an endeavor than most people want to take on. Instead of comparing your portfolio to an arbitrary index or composite of indexes that has nothing to do with your life, focus on your sound, long-term financial plan. This means defining your goals, and understanding how much risk is appropriate for you.
Eric Toya, a financial planner in Redondo Beach, Calif., wrote this for NerdWallet.