Nearly everyone has heard of the Dow Jones Industrial Average and several other popular indicators of market activity, but not everyone knows what these indexes mean or how they came to be such important gauges for investors.
Charles Dow developed the Dow Jones Industrial Average, one of the most well known market indicators, in 1896 as a barometer of the performance of the current U.S. business market. The Dow is currently comprised of 30 leading stocks in the retailing, oil, technology, pharmaceutical, energy, consumer goods, financial, industrial, chemical, electronic, automotive, telecommunication and entertainment industries. At its inception, the average was calculated by taking the price of the 30 stocks, adding them then dividing by 30. Over time stock dividends and splits in the component companies have necessitated adjustments to the divisor to maintain the continuity of the index. The divisor allows for comparisons to be made between current and past values of the index overall.
It is important to remember the Dow is comprised of just 30 large-capitalization stocks, meaning it is not representative of the market as a whole. Also, it is a price-weighted index, meaning it is possible for a stock with a higher price to have a disproportionate impact on the overall value of the Dow. While the Dow is narrow in scope, it can provide a good measure of the state of the economy. In other words, if the Dow is performing well the economy could be showing signs of strength.
While most market indexes use a set criteria to determine which companies will be listed, the Dow Jones Industrial Average is selected by a committee. There are no pre-determined characteristics that companies chosen must adhere to, only that they are leaders in their industry. Companies in the Dow are reviewed and adjusted as needed.
Almost as well known and well followed is the S& P 500 Index created by The Standard & Poor's Corporation. This index follows 500 companies in leading industries and is widely regarded as the standard for measuring U.S. large-cap stock performance. The S& P 500 is much broader based than the Dow and is consequently considered a better measure of the broader markets performance. This index also is market-capitalization weighted, meaning it is possible for companies with a higher market capitalization to have a greater impact on the index's overall value. Market capitalization is calculated by multiplying the market price of a company's stock by the number of common shares outstanding.
The stocks contained in the S& P 500 are chosen based on several criteria including market capitalization, liquidity and industry group. These companies tend to be the leading companies and leading industries within the U.S. economy. The components of the index are classified into 10 sectors: consumer discretionary, consumer staples, energy, financials, health care, industrials, information technology, materials, telecommunications and utilities.
Like the Dow, a committee is responsible for the overall maintenance and composition of the S& P 500. This committee, however, meets every month and follows strict procedures and guidelines for making any changes to the index.
There are numerous other indexes that track various portions of the market. Depending on the contents of your portfolio, you and your financial consultant can determine which indexes are most relevant for you to track. Keep in mind that it is not possible to invest directly in an index.
This article was provided by Jason Peck, 770-532-6361 of A.G. Edwards & Sons, Inc., Member SIPC.
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