California CPA June 2023 | Page 13

Which brings us to the question : What is the market return ? Is it the Dow , the S & P 500 , the Russell 1000 or something else ?

The Dow is a rather odd bird with its value computed by combining the share prices of its 30 constituents . So , if one company has a $ 50 share price while another has a $ 25 share price , the former has twice the weight of the latter . That doesn ’ t make much sense . Neither does the idea that just 30 stocks represent the return of the overall U . S . stock market .

With approximately 500 individual holdings , the S & P 500 is a better representation of the U . S . stock market than the Dow . That said , many people would be surprised at how the index is really constructed .

Although dating to 1923 , the S & P 500 became “ capitalization ” weighted in 1957 . S & P was looking for a way to determine what the average return had been for the average U . S . stock market investor . The math to get there had to be simple — which was important before the advent of computer technology . They allocated the relative weight of each stock in the index by its market capitalization , which was simply number of outstanding shares of each company multiplied by the current stock price . The bigger the company value , the bigger its allocation in the index .

Then , the index is rebalanced once a year , according to the relative capitalizations at the end of that 12 months . Positions in stocks that have performed poorly are sold with the proceeds used to purchase

stocks that had gone up more in price . Certainly , this was a clear view of what had happened in terms of market performance , so it was useful as a past performance benchmark . The more important question , however , is whether a capitalization weighted portfolio gives an investor the best chance of obtaining the market return going forward .

The automated process of buying high and selling low can create a “ piling on ” effect where more and more money is dumped into stocks which have outperformed . This creates some interesting weighting issues . Most people following the markets are aware that certain industry segments can have long periods of out-performance — notably tech , financial and energy stocks .

Many people are also aware that the longer the period of outperformance of a specific sector , the more painful the correction can be when valuations become extended . But a capitalization weighted index

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