RCL Capital Management

A Certified Financial Advisor serving investors in greater Pittsburgh, Pennsylvania – Wexford, Cranberry, Marshall, Bradford Woods, Pine, Richland, McCandless, Ross – and beyond since 1997.

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The Dow is a Poor Index

Although the Dow Jones Industrial is the most popular stock market index, there are other market indices that more accurately reflect the market's direction.

The purpose of a stock market index is to provide the user with a performance amount that is representative of the entire market.  The two most common stock market indices are the Dow Jones Industrial Average (the Dow) and the Standard and Poor's 500 (S&P 500).  I recommend that you to follow the S&P 500 instead of the Dow for two reasons.

First, the Dow is comprised of only 30 stocks that are selected by the editors of the Wall Street Journal.  Thirty stocks is a limited sample size relative to the thousands of individual stocks listed on the various stock exchanges.  In comparison, the S&P 500 is comprised of 500 companies.  The larger sample size provides a more accurate reflection of the entire stock market.

Second, the Dow's method of calculation is overly simplistic.  The Dow weights stocks based on the share price rather than market capitalization (share price multiplied by the number of shares outstanding).  Therefore, a stock trading at $100 is weighted twice as much as a stock trading at $50.  The calculation for the S&P 500 weights a stock included in the calculation based on market capitalization which means that a stock trading at $100 with 10 shares outstanding is equally weighted in comparison to a stock trading at $50 but has 20 shares outstanding since they both have a market capitalization of $1,000.  Weighting stocks based on market capitalization instead of the price per share also provides a more accurate reflection of the total stock market.

The Dow is widely reported by newscasters who likely do not have any idea how the index is calculated and is more popular because of its historical significance but if you want a more accurate picture of reality the S&P 500 is the better stock market index to follow.