What are the differences between the Dow Jones Industrial Average (DJIA) index and the S&P 500?
If you open the business section of your favorite newspaper (or go to any financial news website) you will find quotes for the Dow Jones Industrial Average index as well as the S&P 500. They both measure the performance of large cap american stocks. So, how do they differ?
The first and most obvious way in which they differ is the number of components. The DJIA contains 30 stocks while the S&P 500 is calculated based on, not surprisingly, 500 stocks. That mere fact should indicate that the S&P 500 would be a more accurate index (as it includes a greater number of large-cap stocks) but there is one other difference and it is in fact the most important one.
The DJIA is what is called a price-weighted index which means that stocks with a higher price have a higher impact on the numeric value of the index. Since a company’s stock price is not an accurate reflection of the impact of a company within the index (the way for example, market cap would be) it turns out that this value is slightly distorted.
For example, let’s take IBM (ticker: IBM) with a current price of $124 and a market cap of $162 B and Microsoft (ticker: MSFT) which is trading at $28 with a market cap of $244 B. They are both components of the DJIA but as it turns out, a 5% increase in IBM’s stock price would have around 4 times the impact that a 5% increase in Microsoft’s stock price would have on the value of the index. This stems from the fact that IBM’s stock price is around 4 times Microsoft’s stock price. The DJIA completely ignores the fact that Microsoft has 8.77 billion shares while IBM has only 1.31 billion shares outstanding so in fact Microsoft is bigger than IBM (based on market cap, which is a more accurate metric to calculate relative weight on an average) and yet its impact on the numeric value of the index is 4 times less than IBM’s.
On the other hand, the S&P 500 is a free-float capitalization-weighted index, which means that larger companies (based on market cap) have a proportional impact on the value of the index. The only twist that the S&P 500 adds to its calculation is that it bases it on the proportion of market-cap that is free-floating for each company, that is, the total number of shares that are available for trading. This excludes restricted stock (such as the stock owned by insiders or governments and which is not available for trading).
In summary, as a trader I never look at the DJIA and always base my assessment of the US market based on the S&P 500 index. In fact, professional money managers (those managing money for mutual funds, pension funds, hedge funds, etc.) usually have their benchmarks set with the performance of the S&P 500. In other words, if the index returned 10% in a year and their fund (without leverage) returned 15% that means that they did better than they would have if they had just bought the S&P 500 index, either through an Index fund, Index futures or simply through an ETF such as the one for SPDRs (ticker: SPY)
The only reason why the DJIA is so widely reported is because it’s the oldest index in existance and as such, one could go back and compare its value directly all the way back to 1896 whereas the S&P 500 goes back to 1957.