What is the “market”?

Before I try to answer the question of whether or not its possible to beat the stock market; I should first define what I mean by the “market”.

When most investors think of the stock market, they usually think of a free-float adjusted, market capitalization-weighted index, such as the S&P 500. This is what is meant when I write about the “market”.

An interesting question to consider is how did the market-capitalization index come to represent the market? To answer this question, I’ve put together a timeline listing the key milestones in the development of market indices.

The timeline begins with price-weighted indices and ends with market capitalization-weighted indices. Most of the information comes from Peter Bernstein’s excellent book Capital Ideas: The Improbable Origins of Modern Wall Street.

As you read through the timeline, you’ll notice that:

  • Market indices were initially created by newspaper editors (not investors), to sell more newspapers.
  • The indices were originally used to describe what happened over the course of a day’s trading (rather than to benchmark performance or construct investment portfolios).
  • Early indices were poorly constructed.
  • Improvements in index calculation were limited by data processing technology.
  • With the advent of more powerful computers, the index became a way to benchmark the performance of investors.
  • Inspired by modern portfolio theory, investors began to use the index as an investment strategy.

Why does this history matter? Because I don’t think its possible assess the validity of an idea without first understanding where it came from, the purpose for which it was conceived and how it has changed over time.

For example, last week I listened to an online lecture by Professor Aswath Damodaran who teaches valuation and corporate finance to MBA students at NYU Stern. He is an interesting and engaging lecturer, who also generously shares a treasure trove information about investing on his website and blog.

During the class, Damodaran recounted the story of when he contacted a well-known investment data provider to ask how they calculated their beta coefficients. The data provider arranged for Damodaran to come in and meet their “beta man”, who was excited to have the opportunity to finally meet a client.

When he quizzed the “beta man” about an assumption used in his beta calculations, the beta man’s reply was simply “it was here when I got here”.

Damodaran used the story to make the point that there is an lot of “it was here when I got here” thinking in investing. Investors often use models, rules-of-thumb, assumptions, data, even indices without taking the time to question whether or not they are appropriate.

Coincidentally, this is one of the reasons why it is possible to beat the market. But I’ll save that for my next post. In the meantime, here’s the timeline:


Charles Dow, Eddie Jones and Charles Bergstrasser form Dow, Jones and Co.


The first Dow Jones Average appears in the Afternoon News Letter on July 3rd. It consisted of the closing prices of nine railroad and 2 industrial stocks.


The Afternoon News Letter becomes the Wall Street Journal.


The companies listed on New York Stock Exchange are: 12 industrials, 53 railroads and 6 utilities. Banks and insurance companies are traded over-the-counter.


The first strictly industrial Dow Jones Average of industrial stocks is published with the following stocks: General Electric, American Cotton Oil, American Sugar, American Tobacco, Chicago Gas, Distilling and Cattle Feeding, Laclede Gas, National Lead, North American, Tennessee Coal and Iron, US Leather preferred and US Rubber.


Alfred Cowles establishes the Cowles Commission for Research in Economics.


The Cowles Commission publishes a paper in Econometrica entitled “Can Stock Market Forecasters Forecast?” A three-word abstract of this paper runs as follows: “It is doubtful”.


Common-Stock Indexes, by Cowles and Associates, appears presenting the results of the extensive gathering and compiling of data on the stock market, and contains indexes of prices with adjustments for rights, splits, dividends, etc., and of yield expectations, yields, dividends, earnings-price ratios, and earnings for a large group of common stocks comprising ninety to a hundred per cent of the value of all those listed on the New York Stock Exchange, 1871–1939 and for sixty-eight subgroups of these stocks.

It took over 1,500,000 worksheet entries and over 25,000 hours on a primitive Hollerith punch-card computer to calculate the index.

Price-weighted indices remained more popular than market capitalization weighted indices simply because of the time and money it took to calculate the latter as opposed to the simplicity of the former.

The work done by Cowles would go onto become the S&P 500 index.


Standard Statistics merges with Poors Publishing to form Standard and Poors.


Standard and Poors launches the S&P 500. Up until the introduction of cheaper computing power in the early 1960s, the index is only calculated monthly in-arrears.


The first index fund is launched by Wells Fargo with a $6 million investment from the Samsonite pension fund. The fund holds an equal amount in each of the 1500 stocks listed on the NYSE. The need for frequent rebalancing and heavy transaction costs lead to poor performance.


The Wells Fargo and Illinois Bell pension funds each contribute $5 million to the first market capitalization-based index fund. The fund, run by Wells Fargo, used a sampling approach as the seed funding was less than $25m, the amount needed to buy 1000 shares of each of the companies in the S&P 500. When the fund hit $25m in $AuM, it invested in all 500 stocks.


Jack Bogle and Vanguard launch first S&P 500 index mutual fund with $11m in $Aum. The fund is the first index investment strategy aimed at retail investors.


Standard & Poor’s Depositary Receipts (SPDRs) were launched by Boston asset manager State Street Global Advisors as the first exchange-traded fund (ETF) in the United States (preceded by the short-lived Index Participation Shares that launched in 1989).

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