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:
| Aspect | Price-Weighted (Dow Jones) | Market-Cap-Weighted (S&P 500) |
|---|---|---|
| Weight Calculation | Based on stock price | Based on market capitalization |
| Dominant Influence | Higher-priced stocks | Larger companies by market capitalization |
| Impact of Stock Split | Adjusted using a divisor | Automatically adjusted (market cap changes) |
| Example Dominance | Stock at $300 dominates over stock at $50 | Stock with $1 trillion market cap dominates |
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.