Ever wonder what's the difference between the Dow and S&P?
This answers that question - and clears up a few common misconceptions about these indices.
You see, the Dow Jones Industrial Average is the most widely quoted measure of stock performance. It's the second-oldest U.S. market index, arriving 12 years after the Dow Jones Transportation Average, in 1896. (Both were created by The Wall Street Journal founder, Charles Dow.)
But the Dow is not the best gauge of the broad market, as is widely thought.
In fact, there are three big reasons why the Standard & Poor's 500 Index beats out the Dow in the battle for best market indicator.
Take a look.
What's the Difference Between the Dow and S&P: The Real Story
There are a few disappointing shortcomings in the Dow. First is the selection process.
Dow components are chosen and maintained by the Averages Committee, which includes the managing editor of The Wall Street Journal, the head of Dow Jones Indexes research, and the head of CME Group research.
Each average is reviewed at least once annually, but composition changes are rare for the sake of continuity.
Its objective is to include the stocks of well-known, reputable U.S. companies that demonstrate sustained growth and are of interest to a large number of investors. But there are no set rules the Committee must follow when selecting Dow components.
The next problem is range.
The Dow is only comprised of 30 large-cap U.S. stocks, compared to the S&P's 500.
While the Committee tries to maintain balanced sector representation of all industries (except Transportation and Utilities), the small overall number makes the index less likely to truly represent the overall U.S. market, which holds roughly 5,000 publicly traded stocks.
The third issue is that the Dow is price-weighted. Stock price alone is a poor indicator of a company's quality, yet it rules weighting on the DJIA - higher-priced stocks have more influence over the index than the lower-priced counterparts.
For instance, Visa Inc. (NYSE: V) is the Dow's top component, with a share price of around $242. It currently holds a weigh of 8.93% in the DJIA. On the other hand, Microsoft Corp. (Nasdaq: MSFT) trades at around $47 a share. It's weighted at 1.75% on the Dow. That means Visa has roughly five times as much of an impact on the Dow as MSFT - even though MSFT's market capitalization of $392.7 billion is two and a half times larger than Visa's $151.3 billion.
Price weighting also fails to account for differences between respective industry sizes and other fundamental components that are important to determine overall market health.
And that brings us to why the S&P delivers a much clearer picture of U.S. stock performance...
Why the S&P 500 Is the Better Market Bellwether
The S&P 500 Index's companies represent a much more diverse pool than the Dow's 30.
The components are handpicked by Standard and Poor's and assessed by a committee. The S&P 500's Index Committee is made up of a team of economists and index analysts at Standard and Poor's. It follows a set of published guidelines for maintaining the index and meets on a regular basis.
The committee primarily looks at eight factors: market capitalization, place of domicile, liquidity, sector class, length of time publicly traded, listing exchange, financial viability, and public float (the portion of shares owned by the public).
For instance, when it comes to liquidity and financial viability, each company must have positive earnings when adding up the most recent four quarters. In terms of listing exchange, each component must be listed on the New York Stock Exchange or the Nasdaq.
Like the Dow Jones, the S&P 500 has a weighting system. But it's not price-weighted - it's weighted by market capitalization (or "market-value-weighted").
That means that unlike the Dow, the price movements in stocks with higher market caps will have a greater impact on the index's value than the price moves of smaller stocks.
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