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Course 104
Understanding Market Indexes

The Dow

Want to quickly get a pulse on the market? Everyone talks about indexes--the Dow Jones Industrial Average, the S&P 500, the Nasdaq Composite, etc--but most people only have a vague idea of what they actually are.

Let's start with perhaps the most widely followed index in the world: the Dow Jones Industrial Average. Known as just the "Dow" for short, the index is not really an average, nor does it exclusively track heavy industry anymore. The index is composed of 30 large stocks across a wide spectrum of industries. General Motors GM and General Electric GE are the only two companies that have been part of the index since it was created in 1928, and some of the most recent additions include Disney DIS, Intel INTC and Microsoft MSFT. Those aren't exactly industrial names.

Calculating the Dow

The index is calculated by taking the 30 stocks in the average, adding up their prices, and dividing by a divisor. This divisor was originally equal to the number of stocks in the average (to give the average price of a stock), but this divisor has shrunk steadily over the years. It dropped below one in 1986 and was equal to 0.144 as of November 2002. This shrinkage is needed to offset arbitrary events such as stock splits and changes in the roster of companies.

With the divisor at 0.144, the effect is to multiply the sum of the prices by about seven. To look at it another way, each dollar of price change in any of the 30 Dow stocks represents a roughly seven-point change in the Dow.

Because the Dow includes only 30 companies, one company can have much more influence on it than on more broad-based indexes. It's also useful to remember that the 30 stocks that make up the Dow are picked by the editors of The Wall Street Journal, rather than by any quantitative criteria. The editors try to pick stocks that represent the market, but there's an inevitable element of subjectivity (and luck) in such a method.

Despite its narrower focus, the Dow tracks quite well with broader indexes such as the S&P 500 over the long run.

The S&P 500

The Dow Jones Industrial Average usually gets most of the attention, but the S&P 500 Index is much more important to the investment world. Index funds that track the S&P 500 hold hundreds of billions of dollars, and thousands of fund managers and other financial professionals track their performance against this ubiquitous index. But what exactly is the S&P 500, anyway?

First of all, a little historical background. The Standard & Poor's 500 as we know it today came into being on March 4, 1957. The makers of that first index retroactively figured its value going back to 1926, and they decided to use an arbitrary base value of 10 for the average value of the index during the years 1941 through 1943. This meant that in 1957 the index stood at about 45, which was also the average price of a share of stock. The companies in the original S&P 500 accounted for about 90% of the value of the U.S. stock market, but this percentage has shrunk to about 75% today as the number of stocks being traded has expanded.

The S&P 500, Part 2

Although it's usually referred to as a large-cap index, the S&P 500 does not just consist of the 500 largest companies in the U.S. The companies in the index are chosen by a committee at Standard and Poor's, which meets monthly to discuss possible changes to the list. They choose the companies on the basis of "market size, liquidity, and group representation." New members are only added to the 500 when others drop out because of mergers or (less commonly) a faltering business.

Some types of stocks are explicitly excluded from the index, including real-estate stocks and companies that primarily hold stock in other companies. For example, Warren Buffett's holding company Berkshire Hathaway BRK.B isn't included, despite having a market value among the top 30 for U.S. companies. Until recently, the index included a handful of foreign stocks such as Royal Dutch Petroleum RD, but the index is exclusively American today.

Size matters with the S&P 500. Because the companies chosen for the S&P 500 tend to be leaders in their industries, most are large companies. But the largest of the large-capitalization stocks have a much greater effect on the S&P 500 than the smaller companies do. That's because the index is market-cap weighted, so that a company's influence on the index is proportional to its size. Thus, Microsoft MSFT and General Electric GE,with the two biggest market caps among U.S. companies, each accounted for more than 3% of the S&P 500 as of this writing. In contrast, other smaller companies can account for less than 0.1% of this index.

Other Indexes

While the Dow and the S&P are the most famous measuring sticks for the market's performance, there are literally hundreds of indexes in existence. There's the Nasdaq Composite, which measures the performance of over 4,000 stocks that trade on the Nasdaq exchange. Another famous index is the Wilshire 5000 Total Market Index, which strives to benchmark the entire market by measuring the performance of roughly 5,700 American stocks. Other indexes measure the performance of stock markets in a given foreign country, such as the Japanese Nikkei or the German DAX.

At Morningstar, we've recently rolled out our own way of looking at the market's performance. Based on the same methodology as the well-known Morningstar Style Box™, Morningstar's 16 indexes can quickly give an idea of what kind of stocks are driving the market.

The bottom line is that there are multiple tools available to gauge the market's sentiment and performance. Plus, if you are putting money into an investment that mirrors an index's performance, it's a good idea to understand what the index is intended to track and how it is calculated.

Quiz 104
There is only one correct answer to each question.

1 The divisor used to calculate the Dow:
a. Always stays constant.
b. Has been shrinking steadily in recent years.
c. Has been rising steadily in recent years.
2 What is one major difference between the Dow and most other market indices such as the S&P 500?
a. It's calculated by the U.S. government.
b. It includes primarily large-cap stocks.
c. It's not market-cap weighted.
3 How are changes in the makeup of the Dow determined?
a. The editors of The Wall Street Journal make changes whenever they think it's necessary to do so.
b. A stock that dips below a specified market cap is automatically dropped from the index.
c. The members of the New York Stock Exchange vote on all changes to the Dow.
4 The S&P 500 consists of:
a. The 500 largest stocks in the U.S. by market cap.
b. The 500 largest stocks in the U.S. by sales.
c. Five hundred companies chosen by a committee at Standard & Poor's.
5 One of the following three companies is a member of the S&P 500. Select it.
a. Software giant Microsoft
b. Warren Buffett's holding company Berkshire Hathaway
c. Dutch oil giant Royal Dutch Petroleum
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