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Stock Indexes: Dow Jones Industrial Average

The document discusses major stock market indexes such as the Dow Jones Industrial Average and Nasdaq Composite. It explains that stock indexes are used to gauge the performance of groups of stocks and compares different types of indexes. Specifically, it notes that the Dow Jones Industrial Average tracks 30 large, well-established "blue chip" stocks and is price-weighted, while the Nasdaq Composite tracks over 5,000 technology stocks and is market capitalization weighted.

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66 views5 pages

Stock Indexes: Dow Jones Industrial Average

The document discusses major stock market indexes such as the Dow Jones Industrial Average and Nasdaq Composite. It explains that stock indexes are used to gauge the performance of groups of stocks and compares different types of indexes. Specifically, it notes that the Dow Jones Industrial Average tracks 30 large, well-established "blue chip" stocks and is price-weighted, while the Nasdaq Composite tracks over 5,000 technology stocks and is market capitalization weighted.

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K Mahesh
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Stock Indexes

Stock indices are benchmarks that are used to gauge the performance of a group
of stocks. There are many different types of indices and each of them is unique
in its own way. This section will take a look at the major stock indices that
investors use and why they use them.

Dow Jones Industrial Average

The Dow Jones Industrial average is by far the most famous of all the stock
indices. It is composed of 30 widely traded blue chip stocks (large, well-
established companies that are leaders in their respective industries). The 30
stocks are chosen by the editors of the Wall Street Journal (which is published
by Dow Jones & Company), a practice that dates back to the beginning of the
century. The Dow was officially started by Charles Dow in 1896, at which time it
consisted of only 11 stocks.

The Dow is computed using a price-weighted indexing system. Simply put, the
editors at WSJ add up the prices of all the stocks and then divide by the number
of stocks in the index. (In actuality, the divisor is much higher today in order
to account for stock splits that have occurred in the past.) The Dow is highly
regarded for its simplicity and its history.

However, there are some disadvantages in using the Dow as a benchmark. First of
all, the Dow only includes prices for 30 stocks, yet there are thousands of
publicly traded stocks on the market. Critics of the Dow therefore question
whether or not the Dow is a representative snapshot of the market as a whole.
Another problem with the Dow is that it is weighted by price, instead of market
capitalization. So, for example, a stock that trades at $100 but has a market
cap of only $1 billion will receive more weight than a stock that trades at $50
but has a market cap of $5 billion. Most experts agree that market
capitalization-weighted indices better reflect the market's performance than
price-weighted indexes.

Nasdaq Composite

Not surprisingly, the Nasdaq Composite tracks all of the stocks listed on the
Nasdaq exchange. The index dates back to 1971, which is when the Nasdaq exchange
was first formalized. The index is used mainly to track technology stocks, and
thus it is not a good indicator of the market as a whole. Unlike the Dow, the
Nasdaq is market capitalization-weighted, so it takes into account the total
market value of the companies it tracks and not just their prices. Since the
index tracks all of the 5000+ stocks listed on the Nasdaq, it includes more than
just a representative sample of the technology industry. Critics charge,
however, that the index tracks too many small companies whose performance
increases the index's volatility.

About indices

A stock market index is a listing of stocks, and a statistic reflecting the


composite value of its components. It is used as a tool to represent the
characteristics of its component stocks, all of which bear some commonality such
as trading on the same stock market exchange, belonging to the same industry, or
having similar market capitalizations. Many indices compiled by news or
financial services firms are used to benchmark the performance of portfolios
such as mutual funds.
Types of indices

Stock market indices may be classed in many ways. A broad-base index represents
the performance of a whole stock market— and by proxy, reflects investor
sentiment on the state of the economy. The most regularly quoted market indices
are broad-base indices including the largest listed companies on a nation's
largest stock exchange, such as the American Dow Jones Industrial Average and
S&P 500 Index, the British FTSE 100, the French CAC 40, the German DAX and the
Japanese Nikkei 225.

The concept may be extended well beyond an exchange. The Dow Jones Wilshire 5000
Total Stock Market Index, as its name implies, represents the stocks of nearly
every publicly traded company in the United States, including all stocks traded
on the New York Stock Exchange and most traded on the NASDAQ and American Stock
Exchange. The Europe, Australia, and Far East Index (EAFE), published by Morgan
Stanley Capital International, is a listing of large companies in developed
economies in the Eastern Hemisphere.

More specialized indices exist tracking the performance of specific sectors of


the market. The Morgan Stanley Biotech Index, for example, consists of 36
American firms in the biotechnology industry. Other indices may track companies
of a certain size, a certain type of management, or even more specialized
criteria— one index published by Linux Weekly News tracks stocks of companies
that sell products and services based on the Linux operating environment.

Weighting

An index may also be classified according to the method used to determine its
price. In a Price-weighted index such as the Dow Jones Industrial Average, the
price of each component stock is the only consideration when determining the
value of the index. Thus, price movement of even a single security will heavily
influence the value of the index even though the dollar shift is less
significant in a relatively highly valued issue, and moreover ignoring the
relative size of the company as a whole. In contrast, a market-value weighted or
capitalization-weighted index such as the Hang Seng Index factors in the size of
the company. Thus, a relatively small shift in the price of a large company will
heavily influence the value of the index. In a market-share weighted index,
price is weighted relative to the number of shares, rather than their total
value.

Traditionally, capitalization- or share-weighted indices all had a full


weighting i.e. all outstanding shares were included. Recently, many of them have
changed to a float-adjusted weighting which helps indexing.
Indices and passive investment management

There has been an accelerating trend in recent decades to create passively


managed mutual funds that are based on market indices, known as index funds.
Advocates claim that index funds routinely beat a large majority of actively
managed mutual funds; one study claimed that over time, the average actively
managed fund has returned 1.8% less than the S&P 500 index. Since index funds
attempt to replicate the holdings of an index, they obviate the need for— and
thus many costs of— the research entailed in active management, and have a lower
"churn" rate (the turnover of securities which lose favor and are sold, with the
attendant cost of commissions and capital gains taxes).
Indices are also a common basis for a related type of investment, the exchange-
traded fund or ETF. Unlike an index fund, which is priced daily, an ETF is
priced continuously, is optionable, and can be sold short.

Ethical stock market indices

A notable specialized index type is those for ethical investing indices that
include only those companies satisfying ecological or social criteria, e.g.
those of The Calvert Group, Domini, Dow Jones Sustainability Index and
Wilderhill Clean Energy Index.

Another important trend is strict mechanical criteria for inclusion and


exclusion to prevent market manipulation, e.g. as in Canada when Nortel was
permitted to rise to over 50% of the TSE 300 index value. Ethical indices have a
particular interest in mechanical criteria, seeking to avoid accusations of
ideological bias in selection, and have pioneered techniques for inclusion and
exclusion of stocks based on complex criteria. Another means of mechanical
selection is mark-to-future methods that exploit scenarios produced by multiple
analysts weighted according to probability, to determine which stocks have
become too risky to hold in the index of concern.

Critics of such initiatives argue that many firms satisfy mechanical "ethical
criteria", e.g. regarding board composition or hiring practices, but fail to
perform ethically with respect to shareholders, e.g. Enron. Indeed, the seeming
"seal of approval" of an ethical index may put investors more at ease, enabling
scams. One response to these criticisms is that trust in the corporate
management, index criteria, fund or index manager, and securities regulator, can
never be replaced by mechanical means, so "market transparency" and "disclosure"
are the only long-term-effective paths to fair markets.

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