Why Stock Market News Might Be Misleading You
Learn to separate the meaningful information from the noise. Knowing the right way to interpret market news can help us to make smarter decisions about how to manage our investments.
The end of 2018 may have felt like a stomach-churning time for those of us following closely. Stocks were volatile, and U.S. markets ended the year with an almost 10% drop. Non-U.S. stocks fared better than that, but they also experienced losses in Dec. It’s understandable if you felt unsettled.
Let’s fast forward a few months. Now the story feels different, doesn’t it? Stock markets saw strong returns in Jan. and Feb., overcoming the losses from Dec. The stark contrast between 2018’s ending and 2019’s beginning gives us valuable insight into how we interpret market changes and the news that surrounds them.
Growth of $1 Across Stock Markets—December 2018 to March 2019
Data source: Xignite. Assumes dividends are reinvested.
You can help avoid this emotional rollercoaster by choosing not to focus on month-to-month performance. It’s a mental strategy that some of the world’s smartest investors recommend. However, market news always creeps into our news feeds in one way or another, especially during market drops. It’s worth reviewing what matters and what doesn’t.
Tune out the noise by avoiding these three common fallacies.
As market news is reported, you should be aware of a few fallacies in the way stock market performance is presented.
1. The Dow Fallacy
The Dow Jones Industrial Average, otherwise known as “the Dow,” is perhaps the most commonly reported stock market index. However, it’s actually a very poor benchmark for most people’s portfolios, especially if you invest in a globally diversified set of stocks and bonds.
- It’s comprised of only 30 large-cap U.S. stocks. The limited number of stocks in the index does not give an accurate overall representation of the U.S. stock market.
- The index is price-weighted, which means that stocks with a larger share price influence the index more than stocks with a lower share price, regardless of the relative size of the company or industry.
Other widely reported indexes also have problems you should look out for:
- The S&P 500 only accounts for the 500 largest stocks in the U.S. The performance of mid-cap and small-cap stocks is not captured at all in this index. Moreover, like the Dow, performance of international markets is also missed. Unlike the Dow, the S&P 500 uses market-capitalization weighting, which avoids the pitfalls of a price-weighted index. In the S&P 500, the companies are represented in proportion to how much of the overall market they make up.
- Or, if you watch the Russell 3000, it captures the market-cap weighted performance of the largest 3,000 stocks in the U.S. market, which represents about 98% of the total U.S. stock market. Like the S&P 500, it weights them relative to their size, but still it’s only U.S. stocks; the Russell 3000 does not consider international companies.
So, if all of these indices aren’t effective benchmarks for a globally diversified portfolio, like Betterment’s, what index can you look to? Well, if you’re investing in 100% stocks, the MSCI All Country World Index is a good choice. It’s a market-cap weighted index that covers U.S., international developed, and emerging market economies.
2. The Points Fallacy
The performance of indices like the Dow is often reported in terms of points, which describe the nominal changes in the value of the index. The problem with points is that they count for less and less as the index grows in value. For example, ten years ago, the Dow was at approximately 7,300. A 150-point drop in the Dow would have been a 2% decline. Currently, it hovers around 25,000 or 26,000. A 150-point drop now would be about a 0.60% decline.
When an index experiences a major swing in either direction, the points will usually be a larger number than in the past, since the value of the index has grown. For example, a 2% decline in the Dow today would be about a 500-point drop.
Scary news headlines like “Dow loses 500 points” can be particularly unsettling. We get it. But, if you recognize that 500 points just ain’t what it used to be, you’ll quickly realize that this only means a 2% drop—something that is not particularly uncommon.
It’s better to think about performance in terms of percentage changes, rather than in terms of points. This way, you will not be influenced by large point changes that are simply the result of the index having grown over time.
3. The Urgency Fallacy
It’s also smart to remember that news writers want you to read their stories. They want to grab your attention, which often ends up looking urgent and dramatic. We’ve all seen headlines like “Dow Jones plunges” or “Three things you need to know about the market right now.” Though these types of headlines might increase readership, they may not necessarily help us make good financial decisions. Ignoring the bait should help turn your emotional roller coaster ride into smooth sailing.
Focus on what matters, and ignore what doesn’t.
As investors, it’s in our best interest to separate the meaningful information from the noise. Remember that the Dow is not really the best way to understand market performance, and that points can mean different things depending on the value of the index.
Knowing the right way to interpret market news can help us to make smarter decisions about how to manage our investments. When you’re investing for the long haul, reacting to a news story is rarely a smart decision.
This is one of the many reasons why Betterment automates many parts of portfolio management for you. Our rebalancing and tax loss harvesting features don’t read the news; they look at the data and help you make the right moves in your portfolio so that you can reach your investing goals.