Thursday, 6 June 2013

What is the difference between the Dow Jones and the S&P500?

Anyone who is even slightly interested in the share market would have heard these two indexes.  They are mentioned constantly.  In fact, on the nightly news, when they talk about the share performance for the day it is often with reference to these two indexes.

Both these indexes seek to measure the performance of the US share market and cover US listed companies.  However they are fundamentally different both in the scope of what they cover as well as the way in which they calculate movements in the share market.   It is useful, therefore, for investors to have an idea of what they are hearing when they hear that the index has moved significantly and more importantly if investors are looking to invest in index funds - that they know what the difference between the indexes are.

Dow Jones Industrial Average

The Dow Jones Index is also known as the Dow Jones Industrial Average.  It was created in 1896 and is the second oldest index in the US.  Contrary to it's name, it is not really an average of 'heavy' industrial companies but rather covers the largest US listed companies.

How many companies are in the Dow Jones Industrial Average?
There are actually only 30 companies in the Dow Jones Index making it one of the smallest 'broad based' indexes by number of companies.

How are movements in the Dow Jones Index calculated?
I will not go into the details here but it is important to note that the Dow Jones is a price weighted index.  This means that the movements in the index reflect movements in the share prices of the shares in the index.

This has some important ramifications.  The size of the company does not impact the amount the movement it's share price has on the index.  For example, even if company A is 5x the size of company B and A's share price falls by 10% while B's rises by 10%, the net effect (all other things being equal) is that the index would not move.

There is an adjustment calculation for things like share splits and bonus issues so that these do not affect the level of the index.


The S&P500 is a more broad based index than the
Dow Jones Industrial average.  Created in it's current form in 1957 it seeks to track the movement in US listed stocks using a market capitalisation weighted average methodology.

How many companies are in the S&P500?
As the name would suggest there are 500 companies in the S&P 500 which must be listed on either the NYSE or the NASDAQ.

How are movements in the S&P500 calculated?
As mentioned above the S&P500 is a market capitalisation weighted index.  This means that the index movements are calculated with reference to the market capitalisation of the companies in the index.

This is different to the price weighted index of the DJIA and also has some important ramifications.  For example the size of the company matters.  What you are summing for the calculation of the index is the market capitalisation of the companies.  For example if a $100bn company increases in value by 10% this is going to have 10x the impact of a $10bn company increasing by 10%.  This means that companies with large market capitalisation's (e.g. Apple) have much more of an impact on the index movements than companies with smaller market capitalisation.

If you only had to look at one which index would you use?

It really depends on what you are using it for. I tend to look at the index performance to see what the US market has done the previous day or as a quick reference point to see what it is currently doing and as such tend to focus much more on the S&P500.  It covers a broader range of companies and sectors and also it weights companies by their relative size meaning that you are getting a truer view of what the share market has done in the previous day.

You May Also Be Interested In
I am no longer a believer in the Efficient Market Hypothesis
What does 'generating alpha' mean?
What are bitcoins and should you invest in them?
What is NAV (net asset value)?

No comments:

Post a Comment