What, exactly, is "the market?"

You hear it all the time.“Great day for stocks. The market was up over 200 points.”“The market took a beating, it was down 150 points.”But what, exactly, is “the market”? Well, what they are likely referring to is the most commonly quoted stock market index, the Dow Jones Industrial Average (DJIA). It’s an index of 30 large U.S. companies that was started in 1885 (with only 12 stocks at the time) by Charles Dow, one of the original publishers of the Wall Street Journal, as an effort to increase participation in the stock market, thus sell more newspapers.Today the DJIA measures the daily movement of 30 large companies selected in an attempt to represent the broader market. But the real question is why, in a market of thousands of companies, do we follow an index that only tracks 30 of them?I think the reason is the same for why we’re not on the metric system.I remember, as a kid, we kept hearing about how much better the metric system is and that America will eventually transition to it. I remember seeing Kilometers on road signs next to the miles. I’m not sure what happened to that. I don’t know if it was the expense of adding the meters to the signs, but it never took. I’m not even sure if my car’s speedometer has km/hr next to the corresponding MPH.Still, I don’t think there’s much debate that the meter system is superior to the Imperial unit system that we use. Quick, how many stones in a ton? No, I don’t have any clue either. How about this: how many grams in a kilogram? Yep, 1000.So, if it’s so much better, why don’t we use it? Other than 2L soda bottles, 750ml wine bottles, and 5k and 10k races, I can’t think of many examples in which Americans use the metric system.Much of this has to do with perspective. Just like when you first learn a foreign language, you automatically translate every word back to your native language in order to understand or speak the new language. Eventually, you reach a level of fluency, and no longer need to translate the word in order to understand it. Similarly, if I see my doctor and he told me that I need to lose 5 kilograms, I would ask him to convert that pounds. But if I told me that I need to drop 10 pounds, I immediately have a concept of what that means. Oddly, despite my familiarity with 2L because of soda bottles, if someone said that they consumed two liters of beer, I would think that that sounds like a lot, but not be totally sure. But if they said that had four and a half pints of beer, I would have a clear picture of how much beer that is (it’s a lot).The Imperial unit system is a shorthand that allows Americans to speak the same language without anyone having to do any converting or translating.Similarly, we have been speaking about the stock market with the shorthand of the Dow Jones Industrial Average. If you asked me how the market did today and I replied, “good, the Russell 3000 was up 60 points,” would you have any perspective on what that means? Is that a lot? You bet it is. Based on a recent closing price, it’s around 5.1%. To put that in perspective (or to translate it), the Dow Jones Industrial Average would have to increase 870 points for an equivalent move. I’ll bet you don’t have to google it to know that that’s a lot.Here’s the real question: other than having to convert other indices to the DJIA equivelant movement, is this a problem? The answer is an unequivocal yes.By following such a narrow index, we get a skewed perspective on the market. The 30 large companies in the DJIA often move up or down in similar fashion, but not in line with the thousands of other stocks traded both in the US and overseas.For example, from 12/31/1999 to 12/31/2009, the DJIA went from 11,497.12 to 10,428.05, a loss of 9.30% over the ten year period. Consider that over the same period NYSE Composite, a much more broad index, went from 6,876.10 to 7,184.96, an increase of 4.50% over the same period. International stocks fared even better with the EAFE index gaining 12.38%. Even more, the Russell 2000 index of small cap US stocks increased 23.90%.The DJIA provided a poor perspective of the broad market’s price movement over that time period. Investors who lost money from the end of 1999 to the end of 2009 likely read the press about the “lost decade” in which the DJIA lost over 9%. Seeing that, they may have assumed that their portfolio was average, when in fact, it was not.Looking at shorter periods of time, there are days in which the DJIA is simply out of sync with the rest of the market. Recently, on September 15, the DJIA gained 0.26%. A pretty small move either way, so what’s the big deal? Well, it was a poor indication of what actually happened in the market that day. Most other indices were negative, and in fact, out of the 3,253 stocks that traded on the NYSE that day, only 1,064, or a third of stocks finished the day positive. Nearly double that number, 2,085, lost ground. Yet the most widely followed US stock market index told investors that “the market” finished the day positive.