If you rely on the media, and particularly the local media, for your coverage of the stock market, you will find that the Dow Jones Industrial Average (DJIA) is the most oft-quoted measure of how the stock market performed on a given day. And every time the Dow reaches another multiple of 1000, the party hats reappear and balloons fall to celebrate attaining another market milestone.
And yet most stock market professionals - portfolio managers, analysts, strategists and the like - will refer to the S&P 500 Index instead of the DJIA as their preferred yardstick of market performance. Why is this?
The answer lies in the idiosynchratic way in which the Dow is calculated. Most major market indices, the S&P 500 among them, are market-capitalization-weighted. In other words, those companies whose outstanding shares have the highest aggregate market valuations receive the greatest weightings in these indices. So, for example, Microsoft has the biggest weighting in the S&P 500 right now (just recently edging out Apple) because its market capitalization, i.e. the number of its outstanding shares x its market price per share, is the largest among U.S. companies.
The DJIA, on the other hand, is a price-weighted index. That is, whichever of the 30 stocks in this index has the highest current market price per share receives the greatest weight in the index. Currently, that honor belongs to Boeing.
The other factor that makes the DJIA less representative than the S&P 500 of the U.S. stock market as a whole is that the Dow index only has 30 stocks in it, whereas the S&P 500 has (unsurprisingly) 500 stocks in it. As a result, what happens to the stock price of any given stock within the S&P 500 Index tends to have a fairly small effect on the overall index. Even Microsoft only has a 3.8% weighting. By comparison, Boeing has a 10% weighting in the Dow, and four other stocks have a weighting in excess of 5%.
On most days, the difference in how these indices are calculated doesn't really matter much, and percentage moves up and down tend to be similar. However, during the few weeks every quarter when Dow stocks (and especially those Dow stocks with high stock prices) report their earnings, using the DJIA as an indicator of market performance can be quite misleading.
This can also be the case when one of these high-priced DJIA components experiences other company-specific volatility. Boeing's stock closed at its all-time high price on March 1, but has fallen more than 13% in the weeks since as airlines have grounded some of its planes and cancelled orders for others. Because of Boeing's outsized influence on the DJIA, the Dow Jones SPDR ETF has also fallen during this same time period, whereas the S&P 500 SPDR ETF (with a Boeing weighting of only about 1%) has climbed a respectable .7% during these four weeks. Boeing's recent poor performance and its effect on the DJIA would lead you to believe that March was a poor month for the U.S. stock market, when in fact the opposite is true.
The moral of the story then is to try to use the S&P 500, rather than the Dow, if you're looking for a gauge of stock market performance. In all likelihood, many of the domestic stock mutual funds you own will be using the S&P as their benchmark anyway.
About the Author
Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses. To contact Paul, please click here.