Aug 28, 2020 4 min read

Headlines do not always tell the entire story.

We hear every day whether the Dow Jones Industrial Average and the Standard & Poor’s 500 were up or down. Many people judge the stock market this way, yet many do not understand exactly what these indexes represent.

Who decides the companies that are included and how often do they change?

These indexes are created by private companies. They attempt to reflex the total market, but the indexes have big differences.

The companies that created them earn licensing fees from the mutual fund, exchange-traded funds, and insurance companies that use baskets of securities that try to copy the index and are then sold to investors. To earn more fees, there is an incentive to try to capitalize on stronger market trends.

Many investors are passive, which means they do not try to select what individual stocks will outperform the overall market. Some studies show that indexes actually outperform more active stock selection. Fees are usually lower in index products because they need less research because the index is just being copied.

The S&P 500 is the broader of these two indexes. It is made up of the 500 biggest U.S. companies by market-cap weight. This means the total value of all stocks and bonds issued by the company. The top six companies now represent about 20% of the total value.

It did not used to be that way, but Apple, Facebook, Amazon, Google, Netflix and Microsoft have had their market capitalization explode. Goldman Sachs estimates that more than $300 billion of investments follow the S&P.

Sometimes, an S&P stock is replaced because, like Heinz, it is bought out by another company. Sometimes, for companies like Macy’s, the stock price fell too low. That recently happened during the COVID-19 crash.

The Dow features only 30 stocks. It is price-weighted, and Dow uses a little different set of numbers than the S&P 500. The Dow will change three of its stocks Monday.

This is all happening because Apple is doing a four-for-one stock split. A stock split happens when a company’s board of directors becomes concerned its share price is going too high. Apple was selling for about $500 per share. A four-for-one split would reduce the share price to about $125 per share.

Your total value would not change because of the split; you would just own four times as many shares. This makes it less expensive for investors to buy into the company.

One company that does not believe in splitting stock is Berkshire Hathaway. Warren Buffett’s company’s Class A stock price is currently about $321,224 per share. Most people cannot afford to buy one share. There are some B shares at the more affordable price of $213 per share.

The Apple stock split would lower the value of the Dow, but does nothing to change the value of Apple itself. It will still sell exactly the same number of cell phones and other products as it would have without the split. Its profit will be exactly the same, but Dow Jones wants to protect its interest so it is dropping three current Dow component companies and adding three new ones. Exxon Mobil is being replaced after 92 years in the index.

Also being replaced is the pharmaceutical giant Pfizer and defense contractor Raytheon. The three new companies being added are cloud software company Salesforce, biotech company Amgen and manufacturer Honeywell.

While these changes do make the index look better, they change nothing in the underline economy.

Next week, we will discuss how many stocks have been lagging the overall indexes since the COVID-19 crash.

Gary Boatman is a Monessen-based certified financial planner and the author of “Your Financial Compass: Safe passage through the turbulent waters of taxes, income planning and market volatility.”

To submit columns on financial planning or investing, email Rick Shrum at rshrum@observer-reporter.com.