Dow Jones is price-weighted, unlike other common indexes such as the Nasdaq Composite or S&P 500, which use market capitalization. Please explain this with examples.

The Dow Jones Industrial Average (DJIA) being price-weighted means that the index is calculated based on the prices of its constituent stocks, rather than their market capitalization. Here’s a detailed explanation with examples:

1. Price-Weighted Index (Dow Jones)

In a price-weighted index, the weight of a stock in the index is proportional to its price per share. This means that higher-priced stocks have a greater impact on the index movement, regardless of the company’s overall size or market capitalization.

Example:

Suppose the DJIA has three stocks:

• Stock A: Price = $200, Market Cap = $500 billion
• Stock B: Price = $50, Market Cap = $2 trillion
• Stock C: Price = $25, Market Cap = $1 trillion

In a price-weighted index:

• Stock A has the highest influence because of its price, even though its market cap is smaller.
• Stock B contributes less to the index despite being the largest by market cap.

If Stock A rises by $20 (from $200 to $220), the index moves significantly higher. But if Stock C rises by the same percentage (from $25 to $30), its effect is smaller because of its lower price.

Dow Divisor:

To calculate the DJIA, the sum of stock prices is divided by a factor called the Dow Divisor, which accounts for stock splits and other adjustments. The divisor ensures that the index remains consistent over time.

2. Market-Cap-Weighted Index (S&P 500, Nasdaq Composite)

In a market-cap-weighted index, the weight of a stock depends on its market capitalization (share price × number of outstanding shares). Larger companies by market cap have a greater influence on the index.

Example:

Using the same stocks as above:

• Stock A: Market Cap = $500 billion
• Stock B: Market Cap = $2 trillion
• Stock C: Market Cap = $1 trillion

In a market-cap-weighted index:

• Stock B dominates the index movement because it has the largest market cap.
• A 10% increase in Stock B’s price has a far greater effect than a similar 10% increase in Stock A or C.

If Stock A’s price rises by 10%, it has less impact compared to Stock B’s price rise of 5%, due to Stock B’s higher market cap.

Key Takeaways:

Conclusion:

The DJIA focuses on the price of stocks, which can sometimes distort its representation of the market, as it may overemphasize high-priced stocks that might not be the largest or most influential in the economy. On the other hand, indexes like the S&P 500 and Nasdaq Composite give a more balanced view by weighting companies based on their economic size through market capitalization.