Tuesday, July 11, 2006

Dow and SP 500 Differences

Most introductory finance classes cover the makeup of different indicies. For instance the Dow Jones Industrial Average is price weighted and composed of 30 "blue chip" stocks whereas the S&P 500 is weighted based on market capitalization and includes 500 stocks.

The Street.com looks at some of the implications of this difference:
"What is the impact of the different weighting schemes?....if one of the Dow stocks has a big move higher or lower, as 3M (MMM - commentary - Cramer's Take) did Friday..., the disparate impact on the indices is noticeable. The $7.29 drop in 3M accounted for 58.4 points of the Dow's loss of 134.63 points, or 43.38% of the index's move. On the same day, 3M accounted for 0.607 points of the S&P 500's 8.60 point loss, or 7.06%."

he systematic impact of differential weighting over time should lead to a higher actual volatility for the Dow, and it does. Its standard deviation of returns since August 1974 has been 1.021725 times as great as that of the S&P 500....And even though the indices track each other remarkably well over long periods of time, considering their significant differences, they should not be viewed as substitutes for one another on a daily basis. If they were, we should expect both the regression coefficient and the r-squared to be far closer to one than the .855 and .7639 shown."
The article goes on to talk about trading on the differences.

1 comment:

Anonymous said...

Agreed and often these things are missed out by the a researchers and investors.