Dow Jones vs S&P 500: Which is King?

You will notice that I never quote the Dow Jones Industrial Average in any of my market updates. I always quote the S&P 500.  I want to explain why...

It seems to me that most casual investors assume the Dow Jones Industrial index is the definitive barometer of the U.S. stock market. But, it is really not... In fact, it is a deeply flawed index that only gives us a small snapshot of a much broader picture. Even the way it calculates market returns is broken.

Let’s look at why—starting with the basics.

The Dow Jones is an index comprised of just 30 large, publicly traded companies in the U.S. Because it was introduced way back in 1896, it has history on its side. For decades, the media has quoted it as the definitive gauge for the overall stock market.

But herein lies the problem.

There are roughly 800 "large-cap" companies in the United States today, meaning over 800 corporations have a total market value of $10 billion or more.

Right away, you can see that the Dow only captures the movements of about 4% of these large-cap corporations. In other words, the Dow completely ignores 96% of the largest publicly traded companies in the U.S.

Only watching the Dow is like driving down the highway while looking through an empty toilet paper roll. You are not seeing the full picture of what's going on ahead of you.

The Dow Jones is a price-weighted index. This means it places more mathematical influence on a company with a high per-share price than a company with a lower per-share price.

But just because a company has a high stock price does not mean it is more important, or more valuable, than a company with a lower stock price.

Imagine two fictional companies:

These two businesses are exactly the same size. Yet, because the Dow only looks at share price, it assigns XYZ twice the influence on the index as ABC. That makes zero economic sense.

We do not have to rely on fictional examples to see this flaw in action. Look at two actual stocks sitting inside the Dow Jones index right now:

In reality, Apple is roughly 13 times larger than UnitedHealth. Yet, because the Dow only looks at the raw price per share to calculate influence, UnitedHealth is assigned a heavier weighting in the index than Apple.

Because of these flaws, the Dow Jones is an inaccurate gauge of the overall market. It looks at a tiny sliver of American business, and its math ignores actual corporate value.

The S&P 500 fixes both issues. It is comprised of 500 of the largest companies in the country, capturing more than 80% of the total U.S. stock market value.

Furthermore, the S&P 500 is market-cap-weighted. A company's influence on the index is directly tied to its actual size and economic value, not an arbitrary stock price. In the S&P 500, Apple correctly carries 13 times more weight than UnitedHealth because it is a 13-times larger company.

Actual size = Actual weight.  Makes sense.

If the S&P 500 is vastly superior, why does the general public still view the Dow as the go-to market barometer?

Truth be told, it is likely just historical momentum. The Dow was the original index. It has been around for over 130 years, whereas the modern S&P 500 only came into existence in 1957. The Dow simply entrenched itself into everyday media vocabulary long before a better alternative arrived. It was not the best, but it was first—and sometimes that is enough to hold a crown.

We are on a mission to change this paradigm, at least for our own clients.

Our clients almost never hear us discuss the Dow Jones. Instead, we keep our focus locked on the index that captures the true breadth of the U.S. economy and assigns value accurately to the companies driving it forward:  The S&P 500.