Limitations of Stock Indexes & How to Use Them

Market indexes summarize the stock market or a segment of it, offering potential insight into the performance of a group of stocks. 

Indexes like the S&P 500^® (SPX) and the Dow Jones Industrial Average^® ($DJI) can turn the market's complexity into a single number that can be tracked. That's valuable. But differences in the ways indexes are constructed can sometimes distort the data or place a lot of importance on certain stocks over others, which may not be obvious from the headline number. 

Some indexes prioritize the performance of big stocks, giving them a weighting that has an outsize effect on performance. The specific stocks that are selected for an index, like if they're part of a volatile or cyclical sector, can affect performance too. Those factors can explain why two different indexes of large-cap U.S. stocks might show different results. 

Understanding the differences between indexes and their limitations can help you better understand what's happening in the market. There are also several tools investors can use to counteract some of those limitations. 

The construction of an index—the companies it picks to include, the importance it places on any given stock, and the data it uses—is the primary driver behind any perceived difference or limitation.

For example, the $DJI contains 30 of the largest companies across the economy—minus transportation or utility companies. The SPX consists of 500 of the largest companies in the U.S. stock market. The Russell 2000^® Index (RUT), meanwhile, includes 2,000 stocks that are smaller than the largest 1,000 publicly traded stocks. The Russell 3000^® (RUA) tracks them all.

Because these indexes have different constituent companies, it's no surprise that performance of each is often different. But adjustments indexes make, like weighting the importance of some stocks, can have a bigger impact.

As of August 2024, the largest stock in both the SPX and the RUA was Apple (AAPL), with a market capitalization of $3.4 trillion. Its performance, along with other large technology companies, disproportionately drove the performance of these indexes. That's because these indexes are capitalization, or cap, weighted, which means they give more importance to companies with the biggest market cap (the stock price times the total outstanding shares). 

The 10 largest companies in the index contributed about 38% of the index's value as of July 31, 2024, an unusually high level, and eight of those 10 were technology firms. That made the index unusually sensitive to technology performance, hiding underperformance in stocks from other industries. For the first half of 2024, the S&P 500's top-performing sector was communication services, up 18.58%, followed by technology, up 18.01%. The S&P 500 increased by 14.48%. All other sectors lagged the performance of communication services, information technology, and the index as a whole. The worst laggards were materials, up 4.14%, consumer discretionary, up 2.44%, and real estate, down 2.4.

Because an index is an average, it's not surprising that some sectors perform well above average and some well below. Sometimes, the range between the top performers and the laggards is narrow; other times, it's really wide. A less-informed investor might think that the 14% return of the S&P might mean they could buy shares of any given company in the index and likely average close to that return; however, that is rarely the case. For the S&P 500, the heavy weighting on communications and tech is a big influence on that 14.48% return. An investor chasing the trend might decide to look there first for ideas, while a value investor researches the stocks that haven't been contributing as much to the index return to see if there's any reason they think things might improve. 

The $DJI is less sensitive to any one industry because it focuses on the largest businesses. Instead of cap weighting, the Dow price weights the index, focusing on each company's share price. 

In August 2024, United Healthcare (UNH) and its $536 million market cap had the highest weight because of its $580 share price, while AAPL came in 11th despite its $3.4 trillion cap because its shares were at $226. While that means the Dow may give a view of the market less influenced by the technology industry, it doesn't give as much insight about the market's overall performance—just how the big names are doing. 

The index itself has a bias toward stocks with the highest prices, which can sometimes indicate hype and news surrounding a company rather than its actual performance. Additionally, factors like stock splits make it hard to make apples-to-apples comparisons between stock prices. It's always important for investors to do their own research before making any investment decisions. Finally, by focusing on price weighting rather than market cap, the index might not reflect shifts within the broader economy. Some large market-cap stocks like chipmaker Nvidia (NVDA) aren't in the Dow, so changes to its average might not as closely reflect the huge investment that happened in 2023 and 2024 in companies that develop processing units used for artificial intelligence products. 

Looking at multiple indexes, like ones focused on a specific sector or with different weighting, can be one way to avoid too much bias one way or the other. 

Equal-weighted indexes like the S&P 500 Equal Weight Index ($SPXEW) look at members of the index equally to highlight the effects of individual company performance, whether large or small. They can provide useful insight about market breadth, or the percentage of stocks in a given sector or index that trade above the average historical prices of the index. The higher the percentage, generally, the more positive or healthy the overall market may be. 

Comparing past performances of an equal-weighted index to the cap-weighted S&P 500 may indicate potential future trends. In the first half of 2024, the cap-weighted SPX outperformed the equal-weighted index by more than 11 percentage points, according to Liz Ann Sonders, chief investment strategist at Charles Schwab. That spread widened throughout the year because of the performance of mega-cap stocks like Microsoft (MSFT) and Apple, the largest members of the cap-weighted index, Sonders said in the July 2024 Market Snapshot. 

The hundreds of other stocks did not have the same performance. Sonders said that gap could change, however, as investors in the handful of top-performing stocks sell to take profits and as some of the underperformers post solid quarterly earnings results. "The dramatic outperformance up the cap spectrum has flattered the performance of these cap-weighted indexes," Sonders said. "We continue to think that there are opportunities within the so-called rest of the market, including smaller-cap stocks, but smaller-cap stocks should not be viewed monolithically. They're not created equal."

Staying with high-quality stocks by screening for companies that have strong balance sheets, positive profitability trends, high interest coverage, and healthy cash flows is important, Sonders said. Investors can search the Stock Screener on schwab.com by going to the Research tab, selecting Research Tools, and then Stock Screener. Under Basic, choose Index, and then select S&P 500. That starts you off with the 503 companies currently in the index, and you can narrow the research by selecting a variety of metrics like Analyst Ratings, Company Performance, or Financial Strength. 

Looking at technical indicators in tandem with the SPX can help investors find more information that lurks under the index's performance. 

The Relative Strength Index (RSI) is designed to measure a stock or index's momentum, which is the speed and size of price changes. The indicator is meant to give investors an idea about whether a price of the index may be overbought, meaning prices may decline in the near future, or oversold, meaning prices may increase soon. Similarly, the Arms Index compares data about trading volume and the number of stocks that are advancing or declining to indicate bearish or bullish trend signals. 

Indicators can be found on the thinkorswim^® platform under the Charts tab by selecting an underlying, right-clicking on the chart, and selecting Studies. To find indicators on schwab.com, select an underlying stock or index, then scroll to Charts and select Show More.

Indexes can be used for quick updates on the market, but make sure you take the time to dissect the data behind the index so you know what insights they're providing. Stocks that are overweighted based on their share price or market cap may affect how you see the performance of lower-priced or smaller companies. It's important to remember the limitations of the headline number and to take the data with a grain of salt. Comparing index levels with other sources of information like technical indicators and indexes with different constructions can potentially provide better insights to market trends.