Why Does Nvidia Make Up a Smaller Share of the Dow Jones Than the S&P 500 or Nasdaq-100?

At the time of this writing, Nvidia (NVDA +1.70%) is up by 186.6% year to date, pole-vaulting its market capitalization above those of Apple and Microsoft to make it the most valuable company in the world (again). But Friday's 3.2% sell-off in Nvidia left Apple within a whisker of claiming the No. 1 spot back.

For now, though, Nvidia remains the largest component of the S&P 500 (^GSPC +0.80%) and the Nasdaq-100, which is comprised of the 100 largest non-financial companies in the Nasdaq Composite. Nvidia was added to the Dow Jones Industrial Average (^DJI 0.01%) earlier this month. Yet in terms of its weighting in the Dow, it's ranked 21 of the 30 components, at just 2.1% of the index.

The reason why Nvidia accounts for such a small piece of the Dow's calculation compared to its impact on the S&P 500 and Nasdaq-100 actually highlights an important distinction in the way those indexes operate. And it's something you should know about before you invest in top index funds or exchange-traded funds (ETFs).

Image source: Getty Images.

Understanding index structure

The S&P 500 and Nasdaq-100 are weighted by market cap -- the more valuable a company is, the greater the portion of the index its stock makes up. The Dow, by contrast, is price-weighted, so the movements of a company with a higher stock price will have a greater impact on the index than the moves of a company with a lower stock price.  

One might think this would mean that stock splits by its components would cause the Dow to drop. But in fact, the index's numerical value is modified by a figure called the Dow divisor, which is updated as needed to adjust for all the various splits and spinoffs among its components. That keeps those events from moving the needle on the Dow on their own.

That said, adding a stock with a particularly high price to the Dow would give it an outsized influence on the index. A key reason why Nvidia was added to the Dow when it was is that it went through a 10-for-1 stock split earlier this year. If it hadn't, Nvidia would be trading for more than $1,400 a share. That would have disrupted the balance of the Dow, as Nvidia would have made up nearly 20% of the index. Perhaps not coincidentally, all three companies that were added to the Dow this year -- Amazon, Sherwin-Williams, and Nvidia -- underwent stock splits in the last four years.

The components of the Dow are changed based on the decisions of the S&P Dow Jones Indices committee. In recent years, that committee has added more tech-focused companies like Nvidia, Amazon, and Salesforce (added in 2020) to reflect the tech sector's growing influence on the broader market.

Nvidia makes up a smaller share of the Dow because it is a price-weighted index, and Nvidia now has a lower stock price than the median component of the Dow. However, it could grow to have a greater weight within the Dow if it outperforms the other components.

A few companies now dominate the major indexes

If you regularly follow the markets, you'll see frequent reports about the major indexes' movements. But these movements won't mean as much to you if you don't know what's driving those indexes.

These are the top 10 holdings of some of the largest ETFs that track the broader indexes -- the Vanguard S&P 500 ETF (VOO +0.81%), the Invesco QQQ Trust (QQQ +2.19%), and the SPDR Dow Jones Industrial Average ETF Trust (DIA 0.03%). Since ETFs update their holdings on different schedules, Nvidia is the second-highest weighted holding in the Vanguard S&P 500 ETF, but the highest in the Invesco QQQ Trust. Meanwhile, you can see that market cap has nothing to do with the list of top holdings in the SPDR Dow Jones Industrial Average ETF Trust.

Data sources: Vanguard, Invesco, State Street Global Advisors.

The behaviors of a handful of stocks can have major impacts on all three indexes. The Dow only has 30 components, so the fact that 56.3% of its weight is in 10 companies doesn't make it too top-heavy, especially compared to the Nasdaq-100, where the top 10 components make up a whopping 53.3% of the index -- leaving the remaining 90 accounting for less than half the total weight. Even the S&P 500, with 500 companies, has 36.3% in just 10 businesses.

Use indexes in a way that works for you

Investing in index funds and ETFs can be a great way to dip your toes into high-flying growth stocks like Nvidia while maintaining diversification. It's important to know how these broad indexes are built, so you can confidently pick an index fund that suits your needs.

Some investors may be better off fine-tuning their approach by targeting funds that better suit their goals. For example, the Vanguard Growth ETF offers even more exposure to top S&P 500 stocks like Nvidia, whereas the Vanguard Value ETF holds no stakes in Nvidia, Apple, or Microsoft, and focuses instead on large-cap value stocks. There are plenty of low-cost ETFs available designed to suit most objectives and preferences an investor might have, such as value, income, or growth, or large cap, mid cap, or small cap.

In sum, Nvidia now has a significant influence on the performances of the S&P 500 and Nasdaq-100. That could help lift them to new heights, but it could also make them more volatile.