When the first stock market index was created in 1884, there was no motorcar on the streets and no one could imagine, that humans will ever fly in airplanes.
Stock markets – or meeting points for buyers and sellers – were around for centuries, with the merchants of venice or the dutch exchanges. Years later, the London stock market was founded in 1773, New York followed in 1792 and the Bucharest exchange was established in 1882.
But there was no index to follow the stock market developments until the New Yorker journalists Charles Dow and Edward Jones composed an index of 9 railroads and 2 industrial companies for the readers of their daily financial news bulletin called ‘customer’s afternoon letter’.
Over time, the bulletin became ‘The Wall Street Journal’ and the index the ‘Dow Jones Industrial Average’.
Originally, Charles Dow simply added up the closing prices of the components and divided the sum with the number of stocks to get his index. That makes the Dow Jones a price weighted index.
This system has been refined over time, but is basically valid to this day – and it makes the Dow Jones the only mayor price-weighted index in the world.
This is a simple view of the mechanism of a price-weighted index:
Closing price of:
Stock A – 10 Dollar
Stock B – 15 Dollar
Stock C – 25 Dollar
Stock D – 50 Dollar
The sum of all closing prices of 100 Dollars, divided by the 4 components, would result in an index of 25 points.
You surely noticed that with this system a single stock (D) is making half of the index. And you might think, that’s correct, since stock D with a price of 50 Dollar is the most valuable share in our example.
Well, no so fast. The price of a stock is not giving us the complete picture.
Let’s assume, and we stay with our example, stock A is a company who is producing toys for boys and stock D is manufacturing toys for girls. Because there are roughly the same number of boys and girls around, both companies are making similar earnings each year and are valued by the market at 10 million Dollars each.
The only difference is that the boys-company issued 1 million shares and the girls company only 200’000 shares when they went public.
While the investors value the shares correctly and the market capitalization (amount of shares multiplied with the current price) of both company’s is the same 10 million USD, the girls-company has a five times higher weight in a price-index like the Dow Jones.
To avoid such an over-/under representation, almost every other major stock market index, as introduced in last chapter, is a capitalization-weighted index.
In a capitalization-weighted index, the market capitalization of each component is the basis, so that larger companies are carrying a higher percentage in the weighting of an index.
Here you will find a compilation of the currently 100 biggest companies worldwide by market capitalization.
From an investors perspective, the system of a index-calculation based on capitalization is more useful, no doubt. Nonetheless, and thanks to some adjustments in the calculation, the ‘anachronistic’ Dow Jones Industrial is and will remain the most popular index in the world of financial markets.
Facts & figures are essential for any investor, but one ability is equally important when playing the markets: to ask the right questions. More on that in the next chapter: http://www.theleader.ro/ask-the-right-questions/