It's hard to find much fault with the stock market's performance so far this year. With the S&P 500 (INDEX: ^GSPC ) up more than 7% even after the market's current six-day losing streak, only the greediest of investors can complain about returns so far in 2012.
But indexes can hide important information about what's happening with the individual stocks that make up the markets they seek to track. If you never look past the benchmarks to focus on their underlying stocks, you may make false assumptions about the health of certain companies or even entire sectors of the market.
The forgotten stocks of the Dow
Every day, investors see one example of how benchmarks can mislead you. More people follow the ups and downs of the Dow Jones Industrial Average (INDEX: ^DJI ) than any other benchmark. With 30 stocks that cover nearly every industry group in the stock market, the Dow does a good job of representing the entire U.S. economy.
But if you don't understand the mechanics of the Dow, it's easy to draw false conclusions about what's happening with its component stocks. For instance, with the Dow up just about 4% (including dividends) so far this year, you might assume that most of the Dow's stocks are within a few percentage points of that overall return. In reality, though, Bank of America (NYSE: BAC ) has soared 35% in 2012, and it's just one of six stocks that have gains of 20% or more for the year. Yet on the other side, only Hewlett-Packard's (NYSE: HPQ ) drop has exceeded 20%. Looking more broadly, only eight of the Dow 30 stocks have declined versus 22 advancers.
The reason that the Dow doesn't reflect this positive activity to a greater extent has to do with the Dow's price weighting system. Consider one simple example: If IBM had a blowout quarter and rose 10% in a single day, all 29 of the other Dow stocks could each drop 1% without preventing the average from posting a gain for the day. IBM simply has that much weight, and it makes many of the other stocks in the Dow -- especially B of A and HP, both of which are in the bottom four in terms of Dow weighting -- almost irrelevant.
Looking beyond the mega caps
For the S&P 500, this same phenomenon occurs when you focus too closely on the stocks with the biggest market capitalization. As a market-cap-weighted index, the S&P's return disproportionately reflects those mega-cap stocks.
Yet the health of a bull market often rests on the second tier of large-cap stocks, and so far in 2012, they're not doing quite as well as the top tier. Consider: When you look at an equal-weighted version of the S&P 500, you'll find that its year-to-date return is about 2 percentage points less than for the cap-weighted version.
Two percentage points isn't that big a disparity. But when you drill down on particular sectors, as a recent article by Michael Kahn in Barron's did, the impact can be extreme. Kahn found that because of Apple's (Nasdaq: AAPL ) huge influence in the tech arena, its strong performance gave completely misleading information about how the rest of the tech sector was doing. He concludes that you could draw opposite impressions about the sustainability of the bull market for tech stocks, depending on whether you looked at an equal-weighted index versus one in which Apple dominates.
What you need to know
When it comes to the methodologies behind popular market benchmarks, there's no right or wrong answer. The key, though, is that you have to understand how the benchmarks you follow work and where their blind spots are. If you don't even know about the weaknesses of the market benchmarks you rely on, you're bound to make some huge errors in judgment that could end up costing you a lot of money.
One of the best ways to avoid misunderstandings about benchmarks is to look more closely at individual stocks. Dow lovers won't want to miss The Motley Fool's latest special report, where you'll find our picks of three strong Dow stocks that combine dividend strength and promising growth prospects. Or if you're interested in a deep-dive look at Bank of America or Apple, turn to our premium reports on those two stocks to learn much more about their prospects and potential pitfalls.