The S&P 500 and the Dow Jones

Adam Davidson in last Sunday’s New York Times Magazine, on the drawbacks of the Dow:

None of these criticisms will come as news to finance professionals, most of whom use far more precise measures — like the S&P 500 or the Wilshire 5000, which cover more companies more precisely — when making investment decisions.

The S&P 500 certainly covers a wider range of companies.  But in a typical 5-day window its correlation with the Dow is more than 95%.  How much more precise could it be?

It’s good to have fine-grained measures, but it’s also good to know at what point extra granularity stops addding new content.

 

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3 thoughts on “The S&P 500 and the Dow Jones

  1. Andrew V. Sutherland says:

    I agree that the difference in sample size is not necessarily that significant, but the fact that the Dow is price-weighted can make a big difference. Consider that the mere act of splitting its stock would drop IBM’s weighting in the Dow from 12% to 6%, even if absolutely nothing about IBM or any of the other stocks in the Dow changed.

    In general, the Dow is biased toward higher priced stocks, but any rational investor would regard 1000 shares of a $10 stock as equivalent to 100 shares of a $100 stock. Higher priced stocks tend to be ones that have performed well in the recent past. Whether you regard over-weighting such stocks as a good thing or not (and if you believe in buying low and selling high, you should not), you certainly should be aware that it is happening.

    Personally, I don’t know any serious investor who considers the Dow a useful metric when analyzing portfolio performance or making asset allocation decisions, whereas the S&P 500 (and the Wilshire 5000) are standard benchmarks.

  2. JSE says:

    Oh yeah, the price-weighting is shocking! I didn’t know about that until I read Davidson’s piece.

    But still, I’m confused — if the Dow and the S&P 500 track each other almost perfectly, doesn’t that indicate that the crappiness of the Dow methodology doesn’t end up mattering? And if the Dow differed systematically from the S&P 500 (e.g. because it was too highly correlated with stocks that had recently performed well) wouldn’t people be arbitraging the difference?

  3. Andrew V. Sutherland says:

    I’m not quite sure what you mean by arbitraging the difference. When you “buy the Dow” or “buy the S&P 500″ you are really just buying the underlying stocks in each index, at the same price, but in different ratios.

    How you choose these ratios is indeed a big deal, this is asset allocation, and it is really the most important investment decision in any long-term portfolio. And the whole name of the game is to take advantage of differences in the performance of different asset classes over time (which might be what you mean by arbitraging, although this term is typically applied to short-term transactions), both to increase return and (especially) to reduce risk. This is what portfolio management theory is all about.

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