The three major indices have become an economic gospel of sorts. For decades, the Dow Jones Industrial Average, the Standard & Poor's 500, and the Nasdaq Composite have been the economic barometers of note, printed in every major paper, recited by rote by radio news announcers, and covered by major news outlets.
Even the least business friendly news programs typically make a point of at least listing their daily performance with a few major headlines before moving on to other things.
However, as is often the case with something as institutionalized as these indices have become, it's possible that people have come to overlook exactly what makes up these numbers.
It's like Mark Twain once said, "The classics are the books everyone knows but nobody reads." While a relatively small portion of the population can tell you that the Dow Jones is made up of the 30 most prominent industrial companies in the country, it's most likely an even smaller portion who can tell you how the index is calculated. What, exactly, does one point on the Dow Jones correspond to?
So, here's a closer look at what makes up these three major indices, how they're calculated, and what they really mean.
The Dow Jones Industrial Average (DJIA)
By far the oldest and most prestigious of the major indices, the Dow Jones dates back to 1896 when it was founded by Charles Dow, who was also the founder of the Wall Street Journal. Originally just 12 stocks, the index now sits at 30 companies and the "industrial" tag no longer applies as various different sectors are represented.
The 30 stocks that make up the index are selected by the editors of the Wall Street Journal and are intended to represent a cross section of the biggest and most prominent companies in the country. The only company that has remained on the index since its inception is General Electric (GE) , but the companies have always been prominent and recognizable names like AT&T (T) or Coca-Cola (KO) .
The actual calculation of the index is deceptively simple. The Dow is a price-weighted index, meaning that it's weighted by the price of an individual share for each stock. This is one of the major differences between the Dow Jones and the S&P 500, a market-weighted index, but more on that later. The index itself is calculated by taking the sum of the share prices for all 30 companies and then dividing that sum by the Dow Divisor.
The divisor is adjusted to keep things like stock splits or changing one of the companies in the index from affecting its overall value. The current Dow Divisor sits at 0.15571590501117. The Dow's simple formula and limited scope have brought it under criticism from many sources for not being nearly as accurate a representation of the market as a whole as the general public seems willing to accept, but its survival over more than a century speaks to the index having at least some value as a representation of America's biggest and most prominent companies.
The Standard & Poor's 500
The S&P 500 has existed since 1957, when it was created by financial services company Standard & Poor's. Like the Dow, the 500 companies that make up the S&P index are selected by committee, using clear standards but still not representing a rule-based selection process (like the one incorporated by the lesser-known Russell 1000, which takes the 1,000 companies in the country with the largest market capitalization). The S&P 500 does include some companies that are outside the United States, opting to include some previously American companies that have reincorporated outside the United States.
Unlike the Dow, the S&P is a market-weighted index, which means that the companies are weighted based on their overall size rather than their share price. This means that the movement of bigger companies will have a proportionally bigger effect on the index as a whole. If a company's market cap represent 1 percent of the total market cap of the index, the daily price change of that company should represent 1 percent of the index's move that day.
The S&P 500 is also a price return index rather than a total return index, meaning that dividends are not calculated into the index as returns. The S&P also uses a divisor in order to keep the index consistent over time and to smooth out the effects of corporate actions like buyouts, mergers, share issuance, and restructuring events. The divisor, though, doesn't change for stock splits because they don't directly affect a company's total market cap.
Weighting the index for market cap makes the calculation of the S&P significantly more complex than it is for the Dow. The index is recalculated every 15 seconds during the trading day, and the precise mathematics used are more complicated and elaborate than can be reviewed here.
The important factor to remember is that it's market-weighted, so the effect a company has on the index is directly proportional to that company's size. While still less prominent in the eyes of the public than the Dow, the S&P 500 has increasingly been seen as the index of note among industry insiders, and most fund managers are judged by their portfolio performance against the S&P 500.
By limiting itself to just 500 companies, the S&P still makes for a cross section of the biggest companies in America. However, it does have a much broader scope than the 30 companies on the Dow Jones, working in blue chips like Wells Fargo (WFC) or Oracle (ORCL) that aren't listed on the Dow.
The Nasdaq Composite
The Nasdaq Composite Index is not to be confused with the NASDAQ, the second largest stock exchange in the world behind the New York Stock Exchange. NASDAQ stands for the National Association of Securities Dealers Automated Quotations, and the exchange, founded in 1971, is an entirely electronic market. The index that is most commonly referred to simply as the Nasdaq is a composite index of the over 5,000 stocks that are listed on the NASDAQ exchange.
Like the S&P 500, the Nasdaq is market-weighted so that the shifts in the index are weighted to reflect the size of the companies involved. The composite is made up of all securities listed on the NASDAQ not including closed-end funds, convertible debentures, exchange traded funds, preferred stocks, rights, warrants, units and other derivative securities.
The NASDAQ exchange is much more heavily weighted towards tech companies, meaning that the Nasdaq Composite can often be seen as leaning in the same way. Also, because it includes so many more components, the Nasdaq also includes small cap and speculative stocks in its index, making it significantly different from the two other major indices which include only large companies that are well established.
As such, the Nasdaq's value as a predictive index for the American economy is qualitatively different from the Dow or the S&P. The inclusion of so many different companies gives the Nasdaq a far broader base. However, because it's limited to one exchange, it also means that the index reflects a specific segment of the American economy.
The Nasdaq index is often broadly viewed as being largely reflective of the tech sector, but the inclusion of more speculative companies also means that it can also be seen as partially representative of the small cap market as well.
The rise of major tech firms over the last few decades has meant that the NASDAQ exchange is now home to some of the biggest players in the market, including Apple (AAPL) , Google (GOOG) , and Microsoft (MSFT) .
Which Index Best Represents the Total Market?
In short, none of them. Each index represents a different slice of the American equities market and it would be foolish to think that any one can really be reflective of the market as a whole or the direction of the American economy. This may be why the three are most often reported together. While none may be perfect, looking at each three, and understanding what goes into them, can allow for a broader, more nuanced picture of the day's trading to emerge.
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