Want to Better Understand the Dow Jones vs. the S&P 500 and Other Major U.S. Indexes? Learn How They’re Built

Want to better understand the Dow Jones versus the S&P 500 and other major U.S. indexes? Discover how they're built and when the indexes change their holdings.

https://tickertapecdn.tdameritrade.com/assets/images/pages/md/What is the Dow Jones Industrial Average?
4 min read
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Key Takeaways

  • Since 1896, the Dow Jones Industrial Average has been a bellwether, but that doesn’t mean it’s the broadest market indicator 

  • Learn how the Dow is weighted differently from the S&P 500 

  • Why indexes rebalance and what to watch for 

So much of what most people initially understand about investing comes from the business headlines we see and hear every day. Even today, the one we probably notice the most involves the closing number of the Dow Jones Industrial Average® ($DJI). A global institution for nearly 130 years, the Dow is still considered a top barometer of what’s going on in the broader economy.

But it’s clearly not the only one anymore.

With all respect to inventor Charles Dow—founder of Dow Jones & Co and The Wall Street Journal—there’s a reason the $DJI has become a big fish in a bigger pond of major indexes that offer the biggest picture on the markets.

A stock market index measures the performance of a collection of stocks. Today’s primary market indexes are the Dow, S&P 500® index (SPX), Nasdaq Composite® ($COMP), and Russell 2000® (RUT).

Today, many investors believe this group of major indexes—and thousands of subindexes that measure categories of investments large and small across the investment world—can provide a better view of what’s happening across particular industries, businesses of a certain size, and the economy as a whole.

Indexes are a way to measure the performance of a group of assets in a particular way. A stock index is a hypothetical portfolio of shares organized by various industries, company sizes, or other factors. All stock indexes—any investment index, really—has one consistent mathematical process known as weighting.

Weighting determines the influence of shares in any portfolio by using factors like price and market capitalization. More on that below with one key point: Weighting is central to the way indexes are built and the value they have.

So, as you grow as an investor, it’s worthwhile to understand how any index you follow is built.

The Dow is a great place to start that education.

The first famous index: When was the Dow Jones created?

Equity indexes are hypothetical portfolios of stocks built to tell a story of how shares moved throughout a trading day. There’s plenty of helpful resources where you can learn about the history of the Dow and how it works, but in short, Charles Dow invented the index idea in (gulp) 1884 with 11 transport stocks and then created an industrials index in 1896; Originally it contained only 12 stocks before going to its tally of 30. Dow was among a small group of financial publishers who saw indexes as a way to illustrate how investors were responding based on information about the shares they owned—or wanted to buy. The $DJI, then and now, consists of stocks chosen by The Wall Street Journal’s editors over time with names swapped in and out to reflect what those editors believe to be the 30 leading companies that define the U.S. economy.

Now let’s get on the scale: The Dow Jones vs. S&P 500

The structure just described for the Dow makes it sound like a bit like a high school popularity contest. It’s more than that. Well, mostly.

The backbone of any index—not just the Dow—is a set of mathematical rules (an algorithm, if you prefer) used to calculate a single, attention-grabbing number. To get there, all indexes must have some form of weighting system, a standard methodology for measuring the performance of one stock in an index against another.

Some experts may say this is where the real popularity contest comes in. With tweaks along the way, the Dow maintains a weighting system rooted in its history and much unlike its well-known competitors.

The Dow is known as a price-weighted index, which means its value is calculated based on the price per share of each of the 30 stocks divided by a single, proprietary divisor for all. It’s a simple concept. Price-weighting means stocks with the highest prices are given the highest weight in such an index. In fairness to the Dow, its divisor has been rebuilt over time to fit current business realities that affect valuation, such as stock splits, dividends paid, and when company divisions (or whole companies in the Dow) are bought or sold.

But many investors believe blue chips, established companies with well-known products and services and relative stability, don’t always tell a full market story.

Let’s turn to the S&P 500, whose popularity isn’t about having 500 companies to track. Instead, it’s because the SPX is a market-capitalization-weighted index, which many feel is a truer barometer for the broader market’s strength and performance. Market cap measures the total value of a company’s shares, but the S&P 500 is considered more specialized. One reason is the SPX is a “float-adjusted” market capitalization index. Float-adjusted market cap focuses on shares available in the open market day to day, as opposed to restricted shares that may be held out of circulation for years by other companies, governments or officers, and managers or employees.

The S&P 500 follows large-cap companies (those with market caps above $10 billion) across 11 separate business sectors, which is why investors prize it for its wider, more inclusive view of American industry. Its largest companies by weight include Apple (AAPL), Microsoft (MSFT), and Amazon (AMZN).

The Dow, however, is all about institutions like Home Depot (HD), Procter & Gamble (PG), and Coca-Cola (KO). No one would dispute that the Dow 30 represents some of the biggest U.S. employers and global producers of goods and services. They’re influential. But many would argue the Dow’s price-weighted model can occasionally skew the view.

For example, take JPMorgan Chase (JPM) and Goldman Sachs (GS), two financial leaders in the $DJI. JPM is the nation’s largest bank with more than 240,000 employees worldwide and a recent market cap of $408.07 billion; Goldman Sachs employs more than 40,000 with a market cap of $118.4 billion.

As of January 25, 2023, GS was priced at nearly $350 per share; JPM stood at roughly $140, meaning GS would have more than twice the influence in the Dow than the fifth largest bank in the world as measured by S&P Global.

And that’s why knowing how an index is weighted is important. Weighting can paint a more exact picture of what kinds of companies an index is likely to choose or discard, what it will measure over time and, why it’s worth studying their movements against the companies and investment news you follow (see figure 1).

chart displaying what is dow jones

FIGURE 1: LOOK BEHIND THE LINES. The price-weighted Dow Jones Industrial Average ($DJI—candles) is synonymous with the U.S. stock market. But market-capitalization-weighted indexes like the S&P 500 index (SPX—purple) now dominate because they can give a potentially broader view of the economy while offering a more focused view of key sectors. Data source: S&P Dow Jones Indices. Chart source: The thinkorswim® platformFor illustrative purposes only. Past performance does not guarantee future results.

Beyond the weighting game

Investors can spend years learning how indexes work. A good time to pay attention is when indexes change their holdings.

Again, the $DJI and SPX have very different processes for this.

$DJI: Though the $DJI has made dozens of additions and subtractions over the years, it never talks about when substitutions will be made, only that it never uses a fixed, quantitative rule to make selections. Its last additions were Honeywell (HON) and Salesforce (CRM). If the Dow team likes what it sees, it doesn’t change it—PG has been part of the index since 1932.

SPX: The word you might be looking for is “rigorous.” The S&P 500 has changed its composition numerous times over the past 66 years, but the index now rebalances quarterly “to adjust each company’s weighting based on its latest share count and float.” (Many other investment products mirroring the index rebalance at the same time, so it’s a huge source of market volatility.) As for inviting new companies to the club, it is also done by a committee like the Dow uses. Some of the requirements for S&P recruits include having most of its shares in public hands (see above) and a minimum market cap of $14.6 billion.

There are plenty of opportunities to learn more about indexes and other basics of investing, and you won’t have to go far. Here’s a TD Ameritrade video that goes deeper on indexing basics, and consider subscribing to The Ticker Tape’s Daily Market Update to learn more about the markets each morning.
 

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Key Takeaways

  • Since 1896, the Dow Jones Industrial Average has been a bellwether, but that doesn’t mean it’s the broadest market indicator 

  • Learn how the Dow is weighted differently from the S&P 500 

  • Why indexes rebalance and what to watch for 

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