As the second-longest bull market in history rages on and many indexes keep breaking records, it's fair to wonder if U.S. stocks are overvalued and when this run will end. This is particularly important given how difficult it is for investors to outperform the major stock indexes.
New investors should not worry that stocks are overvalued now but instead systematically invest the same amount of money each month, says David Edwards, president of Heron Wealth in New York.
But investors should understand how the three major stock market indexes -- the Nasdaq composite, Dow Jones industrial average and Standard and Poor's 500 index -- operate. All are based on different stock pools and vary greatly in the size and number of companies as well as how they are weighted.
Don't confuse these indexes with the New York Stock Exchange, the largest in the world, with a trading floor in Lower Manhattan, or the Nasdaq Stock Market, the first electronic exchange.
There are other U.S. indexes as well as hundreds of global, country and region-specific indexes including MSCI World, Russell Global, S&P Latin America 40, Japan's Nikkei 225 and Financial Times Stock Exchange 100 Index.
The big three. Most investing beginners, though, will have heard of the S&P 500. The index consists of the top 500 companies on the New York Stock Exchange and the Nasdaq. Stocks in the S&P 500 index are weighted by market capitalization -- the stock price multiplied by the number of outstanding shares -- with a higher weight given to larger companies. "The higher the market cap, the greater percentage a company will have in the S&P 500," says John Weninger, founder of Vision Wealth Partners in Appleton, Wisconsin.
That means a 1 percent move in Apple (ticker: APPL), which is the world's largest tech company and accounts for 3.89 percent of the S&P 500, affects the index far more than a 1 percent move in News Corp. ( NWSA), which is a mere 0.007 percent of the index, Edwards says.
The Nasdaq composite includes more than 2,500 stocks traded on the Nasdaq exchange. "Historically the Nasdaq has listed more speculative companies, but many have turned out to be high performers," Edwards says. Examples include technology companies such as Amazon.com ( AMZN) and Facebook ( FB) or biotech firms like Genzyme, now Sanofi ( SNY), and Amgen ( AMGN). "Over time, the Nasdaq composite tends to grow faster than the S&P 500, though it can be more volatile."
For example, between October 1999 and March 2000, the Nasdaq shot up nearly 80 percent and then fell almost 70 percent during the next three years, says Todd M. Ingwersen, managing partner at The Harvest Group in Waltham, Massachusetts . It took 16 years for the Nasdaq composite to get back to that level, Ingwersen says. "Adjusted for inflation, it is still under its peak in 2000."
Unlike the S&P 500, which draws from the largest companies in 11 sectors, the less diversified Nasdaq is about half technology companies. "Investors have bid up the value of these stocks to represent their increased importance to American consumers," says Chris Hughen, associate professor of finance at the University of Denver. "If they continue to dominate, their price is appropriate."
Still, technology companies can rise and fall quickly, as Blackberry Ltd. ( BBRY) did when it stopped dominating the phone market, and newcomers can come out on top the way Facebook trampled Myspace. Like the S&P 500, the Nasdaq composite is weighted by market capitalization.
By contrast, the DJIA is limited to the 30 largest companies believed to have the greatest impact on the U.S. economy. "The Dow Jones industrial average is the Kim Kardashian of financial metrics," Hughen says. "It is ever popular, and educated people just wonder why."
Charles Dow, founder of The Wall Street Journal, created the index to track what he considered the 12 most important industrial sectors of the U.S. economy in the 1890s, including sugar, tobacco, gas, electric, coal, iron, leather, rubber, cattle and consumer foods and goods. Of the original companies listed, General Electric Co. ( GE) is the only one still on the index today, which now includes behemoths like Boeing Co. ( BA), the Walt Disney Co. ( DIS), Exxon Mobile Corp. ( XOM), Nike ( NKE), Goldman Sachs Group ( GS), United Health Group ( UNH) and McDonald's Corp. ( MCD).
Unlike the other two indexes, the Dow is price-weighted, giving higher-priced stocks more weight and influence. "Market cap-weighted indexes provide better diversification than a price-weighted index," Hughen says. "It's like comparing a horse and buggy to a Tesla ( TSLA)."
It's a poor methodology that investors should avoid because a company with a $100 share price will have twice the effect on the index as a stock that costs $50, Edwards says. He recommends following an index with a broad exposure to many companies.
Core holdings. Investing in the S&P 500 index offers such broad exposure, with most of the money going to well-known large companies with reliable revenue and ready access to credit.
"A core holding of a starter portfolio is either the Vanguard Index Trust 500 mutual fund ( VFINX) or the SPDR S&P 500 Trust ETF ( SPY)," Edwards says. That's because "the S&P 500 represents 9.6 percent of the 5,200 actively traded companies on the NYSE and Nasdaq, but 76 percent of the market capitalization."
Still, Ingwersen says investors may also want to consider the S&P 500 Equal Weight Index ( EWI) to get exposure to smaller companies that typically have more growth potential. Smaller companies have outperformed the market cap-weighted index by almost 90 percent since 2009, he says.
Regardless of how you invest, ask yourself what you are investing for, Weninger says. "If you don't have a plan for investing and are simply saving a certain percentage without knowing exactly how much you'll need, you are setting yourself up for disappointment."
Instead, Weninger suggests creating a financial plan for retirement, your kid's college fund or other savings goals rather than blindingly allocating funds. That way you can see which investments can help you meet those goals and then track your progress.
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