The Dow was up today. That’s great, but what exactly does that mean?

November 01, 2019

Note – this is part one of a two part “lesson” on some basic terminology and investment strategy.  Part two will post in a couple weeks.  This post may be a little drier than normal but I’m trying out some educational type posts to see if there is interest in more like this or not.  Please provide feedback after reading.  Thanks!

So what does it really mean when you see a quick flash on the news that the Dow went up 100 points?   First, let's define a few things.  Indices and acronyms are thrown around in the financial world faster than most can process.  This week I want to take a minute to define the three major U.S. Stock Indices and set the stage for talking about "Index investing" next post.

By definition an Index is a hypothetical collection of securities that represents a particular market or a segment of a market.1

You might be saying that’s nice, but can I have that in English please?  I’ll try, but for me, it’s probably easiest to dig into an individual Index to help you understand them.

Ok so the most popular Index is probably the DJIA – Dow Jones Industrial Average or “The Dow” for short.  The Dow is a collection of large public company stocks which are headquartered in the United States.  There are 30 companies represented in the Dow.  You may not recognize all of them, but these are mainly very popular “name brand” companies. 

The fact that the DJIA only factors in 30 companies is of note, because if one or two companies’ stock prices have very good or very bad days, the DJIA Index can gain or lose more quickly than other broader Indices. 

Next – what does it mean when the Dow goes up 100 points?  This requires an explanation too lengthy for this post, but suffice to say the Dow would go up by 100 points when the collective sum of the share prices of the 30 stocks goes up by about $14.75.2  Put another way, if one of the share prices of one of the 30 stocks goes up $14.75 in a day and the other 29 do not change, the Index will go up 100 points.

If you’re still with me, take a sigh of relief, that’s the most technical I get this week.  😊

 

The other two most common indices are the S&P 500 and the NASDAQ Composite Index.

Two main points about the S&P 500 that differentiate it from the DJIA: 

  1. It is composed of 500 U.S. based stocks
  2. It is a market-cap weighted Index, meaning the larger the company the larger effect its stock price has on the value of the Index. That is to say a 1% gain in Apple share price would have more effect on the S&P 500 value than a 1% gain in AutoZone share price.  (I’m taking a leap and assuming that Apple will still be a much larger company than AutoZone by the time you read this).

Due to the fact that there are 500 companies listed in the S&P 500 Index, many in the financial industry prefer to watch the movement of the S&P 500 as compared to the DJIA to gage the U.S. Stock Market.  I count myself among those that prefer to watch the S&P 500.

 

The last of the 3 major U.S. Indices is the NASDAQ Composite Index.  Differences here are:

  1. It is composed of ALL the stocks traded on the NASDAQ exchange, which is more than 3,300 stocks.3
  2. Companies need not be headquartered in the U.S.
  3. There are a lot of smaller companies included in this Index as compared to the S&P 500 or the DJIA, so while it generally tends to move in the same direction as them, the NASDAQ is not intended to measure the same things.

 

Point three leads me into my whole reason behind giving you the definitions above – there is an Index for just about everything these days – from bonds to stocks to sectors to countries to commodities etc.  Literally hundreds if not thousands of Indices.

Similarly, this has led to creation of Exchange Traded Funds (ETFs) that mimic most or all of these Indices in order to allow investors to attempt to achieve investment returns similar to those Indices.

AND THAT is where I cut off this week’s lesson – next post I’ll talk about the differences between Active and Passive investing (ETF investing is generally thought of as Passive investing).  Hope you learned a little and talk to you next time.

 

Ken

 

1 – Source – Investopedia

2 – Source – Investopedia, Dow Divisor currently ~ 0.1475

3 – Source - Investopedia

The Dow Jones Industrial Average (DJIA or Dow) is a price-weighted index composed of 30 widely traded blue-chip U.S. common stocks. The S&P 500 is a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy. The NASDAQ Composite Index is a market-value weighted index of all common stocks listed on the NASDAQ stock exchange. Market indices listed are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.

This is meant for educational purposes only.  It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. Please consult with a financial professional regarding your personal situation prior to making any financial related decisions.