How Market Indexes Are Created (Dow Jones vs. S&P 500)

Every single day, we are bombarded with numbers from the financial world. News anchors solemnly report that “the market is up 200 points” or “the market fell 1% today.” For most people, this “market” is an abstract concept, represented by a single, ever-changing number. But what is that number? Where does it come from, and what does it truly represent?

That number is a stock market index, and the two you hear about most often are the Dow Jones Industrial Average (DJIA) and the S&P 500. While they are often mentioned in the same breath, these two iconic indexes are fundamentally different beasts. They are built differently, they measure different things, and the story of their construction reveals the fascinating evolution of the stock market itself.

This guide will pull back the curtain on these financial cornerstones. We will explore what an index is, why it’s so important, and then dive deep into the starkly different methodologies used to build the Dow and the S&P 500—a difference between a small, hand-picked club and a sprawling, representative city.

What Is a Stock Market Index and Why Do We Need Them?

Before diving into the specifics, let’s establish the core concept. A stock market index is a statistical measure designed to provide a snapshot of the performance of a specific market or a sector of that market. It’s a curated “basket” of stocks whose collective price movements are tracked to create a single, easy-to-understand value.

Think of an index like a thermometer for the stock market. A thermometer doesn’t tell you if it’s windy or sunny, but it gives you a crucial, at-a-glance reading of the temperature. Similarly, an index doesn’t tell you about every single one of the thousands of stocks out there, but it gives you a vital reading of the overall market’s health and direction.

Indexes serve two primary purposes for investors:

1. To Gauge Market Sentiment: They provide a quick and simple way to understand the general trend. Is investor confidence high (a rising market) or is there fear and uncertainty (a falling market)?
2. To Serve as a Benchmark: This is arguably their most important function. An index provides a standard against which professional and individual investors can measure their own performance. If your investment portfolio returned 8% last year, was that good? You can only answer that question by comparing it to a relevant benchmark. If the S&P 500 returned 12% in the same period, your performance was subpar. If the S&P 500 only returned 4%, you did great.

The Dow Jones Industrial Average (DJIA): An Exclusive, Price-Weighted Club

The Dow is the grandfather of all market indexes. Created in 1896 by Charles Dow, it is the second-oldest index in the U.S. and carries immense historical weight. Its original purpose was to provide a simple, digestible average of the leading industrial companies of the late 19th century—a time of railroads, steel, and sugar trusts.

How Are the 30 Dow Companies Chosen?

The most important thing to understand about the Dow is that it is not a broad market index. It is an exclusive club of just 30 companies. Furthermore, inclusion in this club is not based on a strict set of rules or formulas. Instead, the 30 stocks are hand-picked by a committee at S&P Dow Jones Indices.

The committee’s goal is to select 30 established, “blue-chip” U.S. companies that are leaders in their respective industries (excluding transportation and utilities, which have their own Dow indexes). The criteria are somewhat subjective but generally include:

• An excellent reputation.
• A history of sustained growth.
• High interest among a large number of investors.
• U.S. incorporation and significant U.S. operations.

This selection process means the Dow is not a representative sample of the market, but rather a curated showcase of American corporate titans.

How the Dow is Calculated: The Power of Price-Weighting

This is where the Dow differs most from modern indexes. The Dow is a price-weighted index. This is a simple but critical concept: stocks with a higher share price have a greater impact on the index’s movement, regardless of the company’s actual size or value.

Let’s use a simple three-stock analogy to explain:

• Stock A trades at $200 per share.
• Stock B trades at $50 per share.
• Stock C trades at $20 per share.

In a price-weighted index like the Dow, a 10% move in Stock A (a $20 change) would have a far greater impact on the index than a 10% move in Stock C (a $2 change). This is true even if Company C is a much larger and more valuable company than Company A. The only thing that matters is the absolute dollar price of a single share.

To calculate the index, the prices of the 30 stocks are added together and then divided by the “Dow Divisor.” This divisor is a number that is constantly adjusted to ensure historical continuity when a company is swapped out or when a stock splits. Originally, the divisor was 30, but today it is a very small number (currently around 0.15). This small divisor is why a one-dollar change in any Dow stock’s price results in a multi-point move in the index itself, which is why we see those big headline point swings.

The S&P 500: A Broader, Market-Cap-Weighted Benchmark

If the Dow is an exclusive club, the S&P 500 is a sprawling, representative metropolis. Created in its modern form in 1957, the Standard & Poor’s 500 was designed to be a far more comprehensive and accurate benchmark for the large-cap U.S. stock market.

How Are the 500 S&P Companies Chosen?

Unlike the Dow, the selection process for the S&P 500 is much more rules-based and objective. A committee still makes the final call, but a company must first meet a series of strict, publicly available criteria to even be considered. These include:

• Market Capitalization: Must be a large-cap company (this threshold changes but is in the billions).
• Liquidity: The stock must be actively and easily traded.
• Public Float: A significant percentage of its shares must be available to the public.
• Profitability: The company must have a history of positive earnings.
• U.S. Domicile: It must be a U.S. company.

This rigorous process results in a basket of approximately 500 companies that, combined, represent about 80% of the total value of the U.S. stock market.

How the S&P 500 is Calculated: The Power of Market-Cap Weighting

This is the key innovation and the primary reason most professionals consider the S&P 500 to be a superior index. The S&P 500 is a market-capitalization-weighted index. This means that companies with a higher total market value (share price x number of shares outstanding) have a greater impact on the index’s movement.

Let’s return to our analogy:

• Company A has a market cap of $2 trillion.
• Company B has a market cap of $20 billion.

In a market-cap-weighted index like the S&P 500, a 1% move in Company A’s stock price will move the index 100 times more than a 1% move in Company B’s stock price.

This methodology makes far more intuitive and economic sense. The movement of a corporate behemoth like Apple or Microsoft has a genuinely larger impact on the total wealth in the stock market than a smaller company, and the S&P 500’s calculation reflects this reality.

Head-to-Head Comparison: Which Index Is a Better Indicator?

While both indexes often move in the same general direction, their different construction can lead to different performance readings. So, which one is “better”?

For the vast majority of investment professionals and serious investors, the S&P 500 is considered the far superior benchmark for the U.S. stock market. Its broad diversification and market-cap weighting provide a much more accurate and holistic picture of the health of large American corporations.

The Dow’s price-weighting methodology is now seen as an archaic and somewhat illogical flaw. For example, a company with a $400 stock price has four times the influence on the Dow as a company with a $100 stock price, even if the second company is ten times larger in total value.

Despite this, the Dow remains incredibly popular in the media and public consciousness. Its long history gives it a certain gravitas, and its large point movements—a direct result of the Dow Divisor—make for more dramatic daily headlines.

What This Means for You

Understanding how these indexes are built is not just an academic exercise. It empowers you as an investor.

When you hear that “the market” is up or down, you can now ask, “Which market?” You’ll know that the Dow is a reading from a small, exclusive panel of giants, while the S&P 500 is a much broader census of the entire large-cap landscape. You’ll understand that the S&P 500 is the industry-standard benchmark against which most mutual funds, ETFs, and personal portfolios are measured.

Don’t get caught up in the breathless reporting of the Dow’s daily point swings. Instead, appreciate these indexes for what they are: powerful tools that, when understood correctly, can provide a clearer perspective on your investment journey and the powerful forces that shape the U.S. economy.