Hello. My name is Chad Taylor, managing partner with MDT Financial Advisors here in Houston, Texas.
I recently started a new series of videos called Questions You Were Afraid to Ask. Each month we look at a common question that many investors have, but feel uncomfortable asking. Because after all, when it comes to your finances, there's no such thing as a bad question. In our first video, we looked at the difference between the Dow, the S&P 500 and the NASDAQ indexes. This month, let's discuss a related question.
So Questions You Were Afraid to Ask. Number two, why is the price of the Dow so much higher than that of the S&P 500. Now, before we get started do me a favor, pick up your phone or go to your computer, open an internet browser, and search for S&P 500. The first result will show you the current price of the index. Make note of the number. Next, search for Dow Jones. Now, do you notice how much higher it is? As in tens of thousands of dollars higher. As you know from my last video, the Dow tracks their performance of 30 of the most prominent companies listed on stock exchanges here in America. Think Apple, Coca-Cola, Walmart among others. The S&P 500 meanwhile, measures 500 of the largest companies listed on American stock exchanges. That is why many investors often wonder why the Dow's total price is so much higher than the S&P even though the ladder contains hundreds of more companies, the answer has to do with how these two indexes are calculated. So brace yourself we're about to do some math.
The Dow, for example, is calculated by taking the 30 stocks in the average, adding up their prices, and then dividing the total by the Dow Divisor. Early in the Dow's history this divisor was simply the number of companies within the average. Today the divisor is adjusted regularly to a factor in changes to the list of companies, stock splits, and other events that could have an impact on the overall average. As of this writing, the Dow Divisor is, and I'll put this number up, but 0.15172752595384. In effect, calculating the Dow's value essentially means multiplying the sum of each company's price by roughly 6.5, because the divisor is less than one means it technically functions as a multiplier. Every dollar change in price to a particular stock within the Dow equates to a movement of 6.59 points on the Dow. So you take one divided by that 15172752595384. I know that me probably seems counterintuitive, but that's the math. This multiplication effect is partly why the Dow's value is so much higher than the S&P 500's. You see, even though the S&P contains hundreds more companies, its overall prices lower because of how it's weighted.
Now, take a deep breath before we plunge into the wild world of weighted versus unweighted indices and yes, do a little bit more math. In an unweighted index every company has the same impact on the overall index, no matter it's price or how many shares that are available. The price of the index is determined by simply adding up every company's stock price then dividing by the total number of companies in the index. For example, imagine an unweighted index containing only three companies. If company A went up by 15% company, B went up by 10 and company C went up by 5, the index itself would be up 10%, simply 15 plus 10 plus 5 equals 30, 30 divided by 3 gives you your 10. With me so far? Now most indexes don't work like this however, that's because not all companies are equal. Some are worth more than others or have a much higher volume of shares available to buy or sell. For that reason a simple mean average is pretty unnuanced way of looking at the overall index.
For this reason most indices are weighted. This means the average is calculated by putting more importance or weight on some numbers than on others. It's a more accurate way of looking at data. The S&P 500 is a capitalization weighted index. The Dow by contrast is a much simpler price weighted index. That means that each company is weighted according to its market capitalization. The company share price multiplied by the number of shares available to buy or sell. As you know, some companies are simply bigger than others. Typically, this means they have more outstanding shares, which means a higher market capitalization and more weight within the S&P 500. The result, the price movement of these companies has a much bigger impact on the S&P than that of smaller companies.
For these reasons, the divisor that the S&P 500 uses is much higher than that for the Dow. In fact, it's currently more than 8,000. The equation the S&P uses is much more complex, I'll spare you that algebra. This is all done to keep the value of index down to a more manageable level and to prevent the price movement of a few companies from having an bigger impact on the overall index than they already do. Hence, as of this writing, the Dow is currently over 30,000, while the S&P is around 3,900.
Whew. That was a lot of information to cover one video. Wasn't it? This has also been a much more technical video than I usually try to record, but I hope you get a glimpse into the numbers you see every day in the news. That way, when the media says the Dow finished it X today, and the S&P opened it Y you'll have a better understanding of what that actually means. Because after all, that's a big part of what life is all about. Isn't it? Increasing our understanding of how the world works and then why.
Next month we'll cover a simpler but broader topic, the difference between stocks, bonds, funds, and other types of investments. I hope you have a great month. Thank you.