Your portfolio correlation to a stock market index
January 3, 1999 - © Copyright 1999 Sheldon M. Bell
Many stock market index watchers are not correct in their perceptions of how the stock market major indexes are calculated, and how to compare their portfolio performance with respect to a major index.
Here is a good question for you. Suppose you own all the stocks that make up the Dow Jones Industrial Average (DJIA) of thirty stocks. Suppose you own an equal dollar amount of each of the thirty stocks. Now let us assume that the DJIA gains 20% in a given year. Does your portfolio go up 20% to pace the DJIA gain.? If your answer to this question is yes you are most likely wrong. As a matter of fact your portfolio could have declined by 20% in value.
How is that possible? The answer to this riddle is simple. The DJIA is a price-weighted index. That is to say that the index is computed by giving a higher price stock a bigger mathematical influence than a lower price stock. So if your portfolio has an equal dollar amount of all of the DJIA stocks it will have no correlation to the performance of the DJIA index.
To make things more complicated the Standard and Poors 500 (SP-500) index, which is a broader base representing 500 of the largest corporations, is capitalization weighted not price weighted. So like the example above, if you owned an equal share of every stock in the SP-500, it also would have no correlation to the performance of this index unless you adjusted your holdings to be capitalization weighted and keep it adjusted on an ongoing basis.
Since most investors think in terms of portfolio values, not relative stock prices or capitalization weightings, they tend to invest equally among stocks in their portfolio rather than varying the amount according to price or capitalization weight. For most investors these and other index performance has no relevance or correlation to their own stock portfolio.
I hope that I haven’t burst the bubble of the index groupies, but instead have diminished their passion and anxiety to be DJIA or SP-500 watchers in the future.