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​Why the S&P 500 is a better gauge than the Dow

What sets these two stock market indexes apart?
Dow Jones vs. S&P 500: What’s the difference? 01:32

With both the Dow Jones industrial average and the Standard & Poor's 500 index hitting new records this year, you may be wondering what the difference is between these two benchmarks.

Both comprise large publicly traded U.S. companies that taken together, represent the performance of the broader market. When you hear people say "the market" is up or down by a certain number of points, they're usually talking about the Dow Jones index.

On any given day, when you compare their performance, the percentage gains and losses typically appear to be close. However, when you take a close look at their long-term performance, you can see the S&P 500 index handily outpaced the Dow Jones industrials. According to Morningstar, as of late July, the Dow is up 13 percent in the past year, while the Standard & Poor's 500 has gained 21 percent.

The Dow Jones industrial average is a price-weighted average (meaning the higher an included company's stock price, the bigger the impact of its price movement on the overall index) that's made up of just 30 large companies. It was created by Dow Jones & Co. co-founder Charles Dow and first calculated in 1896. Today, the Dow is maintained by a selection committee at its current owner, S&P Dow Jones Indices, a unit of McGraw-Hill Financial (MHFI).

Although the term "industrial" is included in the Dow's name, it's really broader than that. Industrial sector stocks account for only about 20 percent of the index. But this index doesn't contain stocks of companies in the utility or transportation sectors because separate Dow Jones indices cover those sectors.

The top 10 stocks represented in the Dow as of the end of May 2014 are: Visa (V), IBM (IBM), Goldman Sachs (GS), 3M (MMM), Boeing (BA), Chevron (CVX), United Technologies (UTC), Caterpillar (CAT), Johnson & Johnson (JNJ) and McDonald's (MCD).

The S&P 500 index, however, is a market-cap-weighted average and is far more inclusive. It comprises 500 U.S. companies also selected by S&P Dow Jones Indices. Again, the goal is to represent the broad U.S. economy.

Companies also must meet certain objective criteria. For example, they must have an unadjusted market cap of at least $5.3 billion, and they must have positive earnings when you add up the most recent four quarters. The top five stocks in the S&P 500 index are Apple (AAPL), Exxon Mobil (XOM), Microsoft (MSFT), Johnson & Johnson and General Electric (GE).

The S&P 500 index was originally created in 1957 and was the first U.S. market-cap-weighted index. That means each stock influences the index in proportion to its market valuation (the total value of all stock outstanding of a company). By calculating the index in this manner, it's a company's total capitalization, not its stock price (as in the Dow) that influences the index.

One advantage of doing this is that when a company decides to split its stock, it has no impact on the S&P 500 because its market cap remains the same. The top third of the S&P 500 consists of about 170 stocks.

Alternatively, the Dow's price weighting means a $1 move in any of its 30 stocks will move the index by an equal number of points. So, when a higher-price stock, say $200 per share, gains 1 percent, or $2, it will have a bigger impact on the index that when a $20 stock makes the same gains (1 percent would be only a 2o-cent move).

For example, a 1 percent gain in Visa or IBM would move the Dow Jones much more than similar gains in Johnson & Johnson or McDonald's. The top three or four stocks in the Dow Jones can account for a third of the index's movement in any given day.

Since the S&P 500 better represents the broader U.S. economy and includes many more companies, it's no wonder it's regarded as the single best gauge of large-cap U.S. stocks. Over $1.6 trillion of assets are invested in S&P 500 index funds, and about $5.7 trillion is invested in portfolios that use this index as their benchmark.

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