Broad market indexes such as the Dow Jones Industrial Average and the S&P 500 get a lot of press by the financial media. Their fluctuating price levels are the barometer for the stock market’s performance. The importance of indexes has grown as an entire investment style based on low-cost market-based performance — known as passive investing — has become increasingly popular since the late 2000s.

With this popularity, however, comes a misconception that passive investing is more conservative than other investing styles. It’s critical that investors understand how indexes are constructed and index construction affects investors’ risks and potential returns.

Historically, indexes have assigned weight to constituent companies in three main ways:

Price

The most prominent example is the Dow. The price of each index member is the sole factor in determining the weight each company carries within the index.

Put simply, imagine holding a portfolio in which you hold an equal number of shares of each stock. The companies with the highest share price will have a disproportionate effect on the index’s performance.

An investor can have an unintended overconcen­tration in one company. For example, Boeing in late July was about 8.5% of the Dow — or 8.5% of an investment you have in a mutual fund or exchange-traded fund that tracks the index. Furthermore, within the DJIA, Boeing (at a share value of around $340) has over twice the impact on index returns as does Microsoft (at a share value $140). This is the case despite Microsoft being roughly five times bigger on a market-capitalization basis than Boeing!

Market Capitalization

The S&P 500 is the most notable index that weights constituents based on their market capitalization. When holding a fund that tracks the index, you’re investing a higher percentage into large companies, based on no other factor than their market capitalization (determined by multiplying the share price by shares available). With this type of weighting, Microsoft now has five times the influence on the index’s return as does Boeing.

Another unintended risk lies with an overconcentration in specific sectors, which can have the greatest adverse impact to performance right before market inflections. As a sector leads the index higher, the underlying companies within the sector gain market value and the sector can have a disproportionate weight in an index.

For example, the technology sector had a weight of about 30% of the S&P 500 in 1999 and the financial sector had a 22% weight in the S&P 500 in 2006. As things stand in the summer of 2019, the top five companies in the S&P 500 are Apple, Microsoft, Amazon, Google and Facebook with a combined weight of nearly 16%.

Equal Weighted

All companies held within this type of index carry the same weight. For example, within the S&P 100 Equal Weight Index, each company has a 1.0% weight. This is also true of the BetterInvesting 100 Index. So Boeing and Microsoft under this example would have the same influence on the index’s returns if each company was up the same percentage on a given day.

Understanding market indexes is necessary when evaluating a passive investment strategy. It’s important to recognize risks and acknowledge that many options for investment styles are available. New indexes are routinely created, with new weights based on factor characteristics of companies and even environmental, social and governance ratings. Do the research and understand company and sector-weighting methodologies before adding passive investments in your accounts.