In an earlier article in this series I discussed the use of sample data drawn from a larger population for the purposes of making decisions. The data in the sample must be representative of the larger population in order for it to be useful in decision making. Consider the stock market in general. What is a good way to determine how the stock market is performing? The Dow Jones Industrial Average (DJIA) rose 18 percent from August of 2016 to August of 2017, a tremendous performance. But wait. The Standard & Poor’s 500 stock index (S&P 500) gained less than 12 percent in the same period. The Center for Research in Security Prices (CRSP) index, an even broader index, trailed almost one full percentage point behind the S&P 500 index. Which of these three indexes best represents how the market really performed?
To answer this question, let’s look at how the indexes are constructed. The Dow is an old and simple index, created more than 100 years ago by Charles Dow, the first editor of the Wall Street Journal. There are roughly 2,800 companies currently listed on the New York Stock Exchange, but only 30 stocks are used to calculate the Dow Jones Industrial Average, AND the 30 stocks are weighted by price.
In August of 2017, Boeing had 7.3 percent of the weighting in calculating the DJIA. Goldman Sachs had 7.07 percent of the weight, 3M had 6.47 percent, United Health had 6.04 percent, and McDonalds had 4.91 percent. These five companies represented two tenths of one per cent of the number of companies on the NYSE but they impacted roughly 32 percent of the DJIA.
It should be obvious that which stocks are included in the DJIA and the price of each of these stocks has an impact on the DJIA that is vastly out of proportion to their representation of the market in general. There are better, more representative ways of determining market performance.
The S&P 500 index does a good job of measuring large-capitalization stocks but it misses thousands of smaller companies. The CRSP index is market weighted and is designed to be a benchmark for the entire spectrum of companies on the stock market, making it the most representative of the three indexes.
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About the author: Mr. Roger C. Ellis is an industrial engineer by training and profession. He is a Six Sigma Master Black Belt with over 50 years of business experience in a wide range of fields. Mr. Ellis develops and instructs Six Sigma professional certification courses for Key Performance LLC. For a more detailed biography, please refer to www.keyperformance.com.