Behind The Smoke-Screen Of Financial Indices
Ever thought, “The Dow is up, so life is good!” So have we. But when you dive a little deeper into the ever-present number, you will question that assumption.
“The Dow Jones Industrial Average” sounds simple, but it’s actually a highly specialized number. First, it’s only based on 30 stocks – hardly a barometer for all that’s right or wrong in the world.
Second, it’s a price-weighted index (click here to read the excruciating details). This can lead to some interesting dynamics; for example, price movements in IBM shares impact the Dow almost as much as the impact of all of the bottom-weighted 10 Dow stocks combined due to IBM’s high share price.
And the S&P 500? Not a stock-price index but rather a Market Capitalization-driven index (stock price times number of shares outstanding) in which the total market-value of each of its component companies influences the index.
Which is better? Well, we’d prefer a Market-Cap weighting because it takes into account both the price of the stock and the number of shares outstanding – and thus might be more indicative of the “impact” that a company has on the economy. But some might argue differently…
Either way, when interpreting business metrics, leaders need to make sure that they understand the underlying math and logic. The same holds true when interpreting financial indices.