Stock Indices are constructed to measure the overall health of the current market. In general, if all benchmarks are trending down, the economy is sluggish. When indices are up it assumes the economy in general is doing great. Common stock indices include the Dow Jones Industrial average, S&P 500, Nikkei, Bovespa, DAX and Russel 2000. However, there are few instances where stock benchmarks cannot accurately measure the overall health of the economy. The most popular of them all is the Dow Jones Industrial average. The Dow has been the major benchmark of business news networks about the current condition of the market. Created by Wall street journal editor Charles Dow in May 26, 1896, the Dow Jones industrial average is a price weighted index made up of 30 major stocks. The name has its origins on the foundation of Dow Jones and Company with Edward Jones. There are a lot of criticisms regarding the accuracy of price weighted index. A major flaw noted is that the benchmark is depending heavily on a divisor to even up stock splits. Other stock indices such as the Standard and Poor’s 500 (S&P 500) uses a market capitalization weighted system first introduced in March 4, 1957.
Unlike the Dow Jones Industrial average, the S&P 500 does not use a divisor to compensate for stock splits. The only time it uses a divisor is when a company is dropped out from the index and a new one is inducted. This maintains the value of the index as especially when the market value of the two swapped companies varies greatly in value. Market Capitalization weighted indexes are more favored by seasoned investors as a better constructed index. For instance, consider a price weighted index consisting of two stocks. Company A and B both trading at $100 each. Add the prices of the two and divide it with a divisor of 2 we get 100 as our index. Now when a 2 for 1 stock split is announced for company B, its stock price would drop to $50 even if there is no real change in its market value, the index would be greatly affected if our divisor will remain the same. At this point the divisor would have to be adjusted to compensate for the stock split. Since 100 + 50 divided by 2 would bring our index down to 75, the divisor has to be adjusted to 1.5 so that the benchmark would still register an unchanged value of 100.