Charles Dow is known as the father of modern Technical Analysis. He founded the Wall Street Journal, invented the Dow Jones Industrial Average, and created a series of principles that formed the bedrock of technical analysis and have since been dubbed “Dow Theory.”

Perhaps most importantly, he had one of the best beards I’ve seen.

In honor of Mr. Dow, today we’re taking a look at the different ways indexes are built. It will help you understand why the Nasdaq, S&P 500, and Russell 2000 often move to a slightly different beat.

Do you know why the Dow Jones Industrial Average is so popular among the media and everyday folk?

The answer is because it was the first index created. The year was 1896, and Charlie Dow wanted a way to track the overall stock market. Up to that point, the only way to analyze equities was by looking at the share prices of individual companies. It was tedious and inefficient. So, Sir Chucky decided to build an index that tracked the average price of twelve of the biggest companies in the market. The math back then was simple. He added up the closing price of the dozen and divided by twelve.

Since then, the Index has grown to include thirty companies. Its make-up has evolved alongside the economy and is now representative of industries that didn’t even exist in Dow’s day. This is my favorite graphic illustrating the history of the Dow Jones Industrial Average. It’s hanging in my office.

Pick Your Weighting

Let’s pretend you are Charles Dow reincarnated. You have a dozen stocks and want to create an Index. How should you weight each company in the formula?

Should the most expensive companies have the most weight? If so, you’d be creating a price-weighted Index. The logic would suggest that the highest-priced stocks deserve the most influence because, well, investors like them more. Presumably, this would be because they have a larger market share and are excelling in the current environment.

The Dow Jones Industrial Average is a price-weighted index. At $316, Apple exerts the most influence on the Index. UNH is next at $290. Dow Chemical comes in last at a lowly $35.

Should the largest companies have the most weight? If so, you’d be creating a market-cap weighted Index. Market-cap is a truer reflection of the size of a company than the stock price, so why shouldn’t it be the variable used in creating the index instead of price?

The S&P 500 is a market-cap weighted index. Microsoft is the largest holding with a market cap of $1.4 trillion. Apple is second with a market cap of $1.37 trillion. News Corporation (NWS) ranks last with a market cap of $6.4 billion.

Should each company have equal weight? If so, you’d be creating an equal weight index. This makes sense if you believe each company should have identical representation in the basket.

You’re probably not familiar with it, but the S&P 500 Index does have an equal weight version. In this Index, Apple has the exact influence as News Corporation. The net effect is that is a better representation of what mid-caps and small-caps are doing.

The S&P 500 Equal Weight Index is the most popular and can be tracked using SPXEW, or it’s corresponding ETF ticker RSP.

In tonight’s Coaches Show, we’re going to break down the performance of each Index. Here’s a price comparison:

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