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What you need to know about Dow vs. S500

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POSTED February 24, 2012 8:40 p.m.

Q. What's the difference between the Dow Jones industrial average and the Standard & Poor's 500 average, aside

from the obvious fact that the S&P includes many more stocks?

A. There is a huge difference between the two, and it goes far beyond the fact that the Dow has only 30 stocks, a fraction of the number in the S&P 500.

The Dow Jones industrial average is a "price-weighted" index, while the S&P is weighted by "market capitalization." That is a big difference in terms of understanding the drivers behind movements in the index.

Because the S&P 500 is weighted by market cap, the larger the market cap (price times number of shares outstanding), the more effect that stock has on the daily move of the S&P index.

The Dow weighting is set up so that a $1 move in any of the 30 stocks will move the index by an equal number of points. That sounds fair, until you realize that it is far easier for a high-priced stock to move 3 or 4 points than it is for a low-priced stock to make that large a price move. So, high-priced stocks have more impact on the daily movements of the index.

Thus, because IBM is trading at about $193 per share, it accounts for almost 12 percent of the index. The smallest weighting is for Bank of America, which accounts for only 0.4 percent of the index.

In fact, the price movements in IBM stock affect the Dow nearly as much as the combined movement of the bottom 10 stocks.

But you don't get the daily changes in the Dow merely by adding up the percentage or point change in all 30 stocks and then dividing by 30. It's more complex. The prices of the 30 Dow stocks are added up and then divided by the "Dow Divisor" — a precise number designed to keep the Dow consistent, despite stock dividends and splits. Currently, the divisor is 0.132129493.

The S&P 500 Index is constructed so that each stock influences the index in proportion to its "market capitalization." That is the price of the stock times the number of shares outstanding. So it's the total value of the company that influences the index, not just the price of its stock. And if a company decides to split its stock, its market capitalization remains the same. In the case of a split, there are twice as many shares, each trading at half the original price. So the "influence" of the company in the index is unchanged.

When the S&P 500 is broken into thirds, the top third consists of 166 stocks, which account for 75 percent of the entire index. IBM, which accounts for 12 percent of the weight in the Dow, is the third largest weighting in the S&P 500 Index. But its price changes create less than 2 percent of the index movements, compared to 12 percent of the Dow movement on any given day.

Because of these major differences in how the indexes are constructed and weighted, there is no fixed relationship between the two. About all you can say is that if one of these popular benchmarks is up, or down, substantially, it is likely that the other will also move in the same direction.

 

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