The Dow Jones Industrial Average (INDEX: ^DJI ) is the best-known measure of the stock market. But many analysts are full of scorn for the benchmark, arguing that it unfairly emphasizes the performance of high-priced stocks even when their overall market caps are less than some of their lower-priced peers. As a result, those analysts tend to rely more on the cap-weighted S&P 500 Index (INDEX: ^GSPC ) instead.
But the controversy between the Dow and the S&P is largely unwarranted. Consider: the 30 Dow stocks make up more than 30% of the value of the S&P, which suggests that there will be a fairly high level of correlation between the two benchmarks.
Moreover, looking back at the past 10 years, the disparities in performance between the two measures haven't been all that big. It's rare for the annual returns on the Dow and S&P to differ by more than five or six percentage points, and the Dow seems just as likely to outperform as to underperform the S&P. Indeed, since 2002, the overall difference in average annual return amounts to about a quarter of a percentage point.
What the Dow's missing
What differences there are between the Dow and the S&P amount to two big categories:
- The Dow leaves out a few gargantuan companies, including Apple (Nasdaq: AAPL ) and Wells Fargo (NYSE: WFC ) . When those stocks perform well compared to their peers, as both have over the past several years, the S&P will get a big boost in relative return because they have relatively high weights within the index.
- Obviously, the Dow also leaves out hundreds of the smaller companies in the S&P 500. Yet because of its cap-weighting, those stocks don't have a huge impact on the S&P 500 either. For instance, First Solar (Nasdaq: FSLR ) represents just 0.01% of the S&P 500, so its huge losses over the past year barely make a dent in the value of the index. Nevertheless, though, those smaller large caps often diverge from the megacaps you find in the Dow, and when you add them all up, they often explain part of the difference in returns.
Despite what the Dow is missing, it does a surprisingly good job of tracking broader indexes. As such, much of the criticism that the Dow gets appears unwarranted. At least from a practical viewpoint, there's nothing inherently better about the S&P than the Dow.
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