What is the Market?

Have you ever overheard a conversation about the “market” going up or down a certain number of points? I often wonder whether the people participating in those conversations have taken the time to define which market they are talking about. The differences between markets can be profound, and the risks of investing in those markets is often misunderstood.

Typically, when someone talks about “the market”, they are actually referring to an index. An index is a collection of assets (like stocks) that are grouped together based on some pre-defined criteria. Think of the term “vegetables” for example. All vegetables are a type of plant, but “plants” is an extremely broad category. The term “vegetables” groups similar types of plants into a narrower group. In our analogy, stocks are plants and vegetables are the index. “Fruits” could be yet another index, and so on…

Two of the most popular indexes are the Dow Jones Industrial Average (the Dow) and the S&P 500 (the S&P). Both the Dow and S&P are indexes of large, U.S. stocks, yet the way they are constructed differs substantially. Other examples of indexes include the MSCI EAFE, which consists of non-US companies domiciled in developed countries (like Germany), the MSCI Emerging Markets, which consists of non-US companies domiciled in undeveloped countries (like India), or the Russell 2000, which consists of small US companies. In 2025, there are thousands of different indexes in existence. Indexes were originally designed to provide analysts and investors something they could study and track without having to follow each underlying company. Indexes were NOT intended to be investment vehicles – but more on that later. For now, let’s compare the basic characteristics of the two most popular indexes, the Dow and the S&P:

Clearly, the Dow is more concentrated since it is comprised of only 30 stocks while the S&P includes 500. The stocks that combine to make up the Dow are chosen by a committee based on their perception of a given company’s status in a particular industry. The committee intends to assemble a collection of leading companies from various industries. The S&P 500, on the other hand, is constructed based on numerical requirements such as size, earnings and others. Neither index remains static over time. The companies within each index can be removed and replaced by others that were not previously part of the index. As a result, index performance is said to suffer from “Survivorship Bias” because the worst performers are taken out while the better performers remain. For example, you may recall Sears Roebuck Co. Once a dominant retailer and large component of the Dow, it was removed in 1999 and replaced by Home Depot.

Perhaps the most important element of index construction is how the stocks within each index are weighted. When any index or portfolio is designed, you must determine how much each stock will represent as a percentage of the whole. In the Dow, the weighting of each stock is based on its share price. For the sake of simplicity, let’s assume we add up the share prices of all 30 companies in the Dow and it equals $100. If the share price of one company is $20, then that company will represent 20% of the index. This methodology has been criticized because share prices alone tell us very little about what investors believe the company is worth. In order to make that calculation, we need to know how many shares of the company are outstanding, and multiply the number of shares by the share price. This calculation results in market cap, which is how the S&P 500 weights the stocks within the index.

Market Cap = Share Price x Shares Outstanding

Let’s say the total market cap of all the companies in the S&P 500 = $100,000. If Company A has a share price of $10 and 100 shares are outstanding, it has a market cap of $1000 and will represent 1% of the index. The market cap approach to index construction has been criticized as well, because very large companies have an outsized influence on index performance.

Recall our earlier comment that indexes were NOT designed to be investment vehicles. For better or worse, they have become just that. Exchange-Traded Funds (ETFs) and Index Mutual Funds are investment products that are designed to mirror the performance of an index. These products have their own ticker symbols, but below the surface they invest in each individual company within the index. These products are typically inexpensive to own and are held out to investors as an easy way to get diversified exposure to a particular market. Over the last two decades, these products have exploded in popularity and have come to dominate the investment landscape. However, their growth may present a significant challenge to the longer-term health of markets.

At the end of January, the 10 largest companies in the S&P 500 represented 36.2% of the index. Said differently, just 2% of companies in the S&P accounted for over 1/3 of its value. Whether those top 10 companies are truly that much better than the other 490 is up for debate, but perhaps the popularity of index-based investing itself is to blame for the high concentration we see in markets.

When an investor puts money into an index-tracking product, the product must then buy the underlying stocks in the index. Since the lion’s share of that money is used to buy the largest stocks in the index, their share prices can be forced to increase faster than the other stocks in the index. Reflexively, the biggest get even bigger, and command an even larger share of the next dollar invested.

If the golden rule of investing is to “buy low, sell high”, the very nature of a market cap weighted index investment seems to do the exact opposite! It buys more of the highest-priced companies – and does so with no consideration for those companies’ fundamentals or future growth prospects.

Investors who focus on risk management rather than market returns often impose rules for how their funds are managed. These rules are designed to protect the portfolio from catastrophic losses and may include limits on the size of any one investment, or cap the portfolio’s total exposure to a single industry group. These types of risk controls can reduce returns meaningfully, especially during periods where only one type of investment outperforms all the others.

While it is true that this concentrated market has offered attractive returns in the recent past, it’s important for investors to stay focused on their individual financial goals and pursue them in a manner that mitigates unnecessary risk. For example, if your financial goal is to maintain the buying power of your assets in retirement, then the “market” should be of little consequence to you. As always, we are here to help you define and achieve those goals by employing the process that works best for you! Please do not hesitate to reach out for more information or contact us with any questions.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.