What's the difference between the Dow Jones and the S&P 500?

The Dow Jones Industrial Average (DJINDICES:^DJI) and the S&P 500 (SNPINDEX:^GSPC) are the two most touted market indices. They are indicators of the relative health of the market as a whole and are called upon to give us a quick summary of economic performance. In order to compare the two, I will break down the differences between the Dow and the S&P, their composition, and how to invest in them.

You will notice that the Nasdaq Index (NASDAQINDEX:^IXIC) is usually lumped in with them, however, that does not purport to represent the market as a whole due to its tech-focused composition.

The Dow Jones Industrial Average

The Dow Jones is the oldest and arguably least intuitive index. It consists of 30 large-cap companies that represent the might of American industry. It is made up of household names like McDonald's, IBM, and Boeing and is generally used as a gauge for the relative strength of the U.S. economy.

However, it does have one inherent flaw that makes it less reliable than the S&P as a market indicator: it is price-weighted, meaning the company with the highest stock price actually has the biggest impact on the performance of the index. This little quirk means United Health with a market cap one-fifth that of Microsoft's, has almost twice the sway in the performance of the index thanks to its greater stock price. It also means that the index is irrationally impacted by the price fluctuations of certain companies, Boeing being the main culprit in recent times.

How can I invest in the Dow Jones?

The best way of investing in the Dow is through the SPDR Dow Jones Industrial Average ETF (NYSEARCA: DIA), an ETF that groups the 30 companies and weighs them in the same fashion.

The S&P 500

The S&P 500 Index is a basket of 500 of the largest companies of both the New York Stock Exchange (NYSE) and the NASDAQ. A committee selects companies for the index based on a number of different factors including size, industry, and liquidity, and there are specific requirements that need to be satisfied in order to qualify for consideration:

The company must have a market cap of at least $8.2 billion
At least 50% of the company's stock must be available to the public
The company must have positive earnings for the last four quarters
At least 50% of its assets and revenues must be located in the U.S.

The S&P differs from the Dow in that it is weighted by market cap, meaning the largest companies have the greatest impact on the performance of the index. The breakdown of sectors within the index mimics that of the U.S. economy, showcasing a fair representation of the market's performance across all industries and intrinsically linking itself to the performance of the market as a whole. The index represents 80% of the market cap of the entire stock market. Because of all these factors, the S&P 500 is the most trusted market-tracker. If you hear the term "beating the market," it will always be in relation to this index.

The current 5 largest companies in the S&P right now are:

Apple
Microsoft
Amazon
Google
Berkshire Hathaway

How can I invest in the S&P 500?

The best way of investing in the S&P 500 is through the Vanguard S&P 500 ETF (NYSEARCA: VOO), an ETF that tracks the index and gives the same weights to companies.

What's better: the Dow Jones or the S&P 500?

There really is no better or worse when comparing indices. They represent different swaths of companies and so have different properties. If we want to gauge the market performance over a specific time period or compare your portfolio's performance to a certain benchmark, the S&P 500 provides a more accurate representation of the stock market as a whole. Yet economists, commentators, and politicians will almost always use the Dow as a representation of the stock market and the U.S. economy.

Whether you track the Dow Jones, the S&P 500, or even the Nasdaq, it's important to know the exact makeup of companies and how they are weighted. The more you know, the better investor you become.