After the economic collapse of 2008, a lot of people looked at the state of their investments and wondered just what the heck had happened. The same process takes place on a larger scale throughout the financial services industry. One of the tools analysts use to gauge the market's health is stock indices, such as the Dow Jones Industrial Average and Standard & Poor's 500. Both try to give a snapshot of the American economy by tracking the performance of specific stocks, but there are significant differences in how they do it.
The Dow Jones index was launched in 1896 by Charles H. Dow. He was the first to realize that tracking the performance of specific individual companies could provide a snapshot of the larger stock market. Dow compared it to placing a line of stakes on the beach, to see whether the tide was moving in or out. His original index totalled the stock prices of a dozen companies, mostly railroads, and divided that total by the number of companies. Over the years the index grew to 30 companies, and a carefully-calculated divisor is now used to compensate for the effect of mergers and stock splits.
Standard & Poor's
Although the Dow became a leading economic indicator during its first half-century, its small selection of large companies was sometimes out of sync with the rest of the economy. In 1957 Standard & Poor's, a provider of market intelligence for investors, launched a competitive index that tracked the performance of the 500 largest U.S. stocks as judged by market capitalization. Although the Dow is still quoted on the business pages of most newspapers, advocates of the S&P 500 argue that it is a more accurate reflection of the state of the stock market.
Stock Price vs. Market Capitalization
The Dow and S&P have a fundamental difference in how they value the companies in each respective index. The Dow is weighted by stock price, meaning high-priced companies such as IBM have a substantial impact on the Dow's movements. The S&P is weighted instead by market capitalization. Market cap multiplies the stock price by the number of shares, arriving at a total value for the company. A company with a large market cap represents a bigger share of the stock market than a company with a small cap, regardless of its actual stock price. Therefore, the ups and downs of a large cap should be more representative of the market as a whole.
The Dow and S&P are also different in their makeup. The 30 companies that comprise the Dow are all titans in their fields, major brands that are known in every home. The 500 companies in the S&P represent a broader sample of industries, as well as companies of different sizes. Dow claims its index represents 27 percent of stock market activity within the U.S., while S&P says its 500 companies represent 75 percent of market activity. The broader range of the S&P, and its inclusion of smaller companies, means the two indices are often out of step with each other.
- Thinkstock/Comstock/Getty Images