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It's not unusual for people to talk about "the market" as if there were a common
meaning for the word. But in reality, the many indexes of the differing segments
of the market don't always move in tandem. If they did, there would be no reason
to have multiple indexes. By gaining a clear understanding of how indexes are
created and how they differ, you will be on your way to making sense of the daily
movements in the marketplace. Here we'll compare and contrast the main
market indexes so that the next time you hear someone refer to "the market",
you'll have a better idea of just what they mean.
The Dow
The Dow Jones Industrial Average (DJIA) is one of the oldest, most well-known
and most frequently used indexes in the world. It includes the stocks of 30 of the
largest and most influential companies in United States. The DJIA is what's
known as a price weighted index. It was originally computed by adding up the
per-share price of the stocks of each company in the index and dividing this sum
by the number of companies - that's why it's called an average. Unfortunately, it
is no longer this simple to calculate. Over the years, stock splits, spin-offs and
other events have resulted in changes in the divisor, making it a very small
number (less than 0.2).
The DJIA represents about a quarter of the value of the entire U.S. stock market,
but a percent change in the Dow should not be interpreted as a definite
indication that the entire market has dropped by the same percent. This is
because of the Dow's price-weighted function. The basic problem is that a $1
change in the price of a $120 stock in the index will have the same effect on the
DJIA as a $1 change in the price of a $20 stock, even though one stock may have
changed by 0.8% and the other by 5%.
A change in the Dow represents changes in investors' expectations of the
earnings and risks of the large companies included in the average. Because the
general attitude toward large-cap stocks often differs from the attitude toward
small-cap stocks, international stocks or technology stocks, the Dow should not
be used to represent sentiment in other areas of the marketplace. On the other
hand, because the Dow is made up of some of the most well-known companies in
the U.S., large swings in this index generally correspond to the movement of the
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