It's hard to find much fault with the stock market's performance so far this year. With the S&P 500
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
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
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
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.
Fool contributor Dan Caplinger is always looking for dirty tricks. He doesn't own shares of the companies mentioned in this article. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of IBM, Apple, and Bank of America. Motley Fool newsletter services have recommended buying shares of and creating a bull call spread position on Apple, as well as creating a synthetic long position on IBM. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is always a treat.