Why the Dow Jones is a flawed index

*yawn* Oh hello there! Welcome back. Did you miss me?

Sorry for the extensive delay (348 days), but after five years of vociferous posting, I needed to take some time off. But now I am back! And I am here to talk about everyone’s favorite topic – the stock market.

The stock market is of course the huge soup of publicly traded securities that investors (and algorithms) buy and sell everyday. And to determine how the market is doing, we rely on indexes. The three most popular are the Dow Jones Industrial Average, the S&P 500, and the NASDAQ. The Dow tends to be the default index we use in everyday conversation. It is the oldest and the most famous, and it crosses over big, round numbers more often than the other indexes. Last week, the Dow passed 25,000*, which elicited a tweet from our Dear Leader:

Investing legend Art Cashin even gets a new hat every time the Dow crosses 1,000.

DStOYebX0AI4Gmi

*By the way, in 2014, I made some predictions of things that will happen in my life. One of them is that the Dow will reach 100,000, which is absolutely going to happen (a conservative 3% per year for 50 years will get us there). And one of my predictions has already come true – the Cubs won the World Series!

Hey, there is reason to be excited. The Dow was as low as 6,443 in March of 2009, which means the index has roared almost 300% in the last nine years (not including dividends). This is good news for the 52% of Americans who own stocks.

But there are two flaws with the Dow Jones.

NUMBER ONE, the Index does not capture the performance of the broad market. It only captures the performance of 30 stocks which are arbitrarily selected, can change year-to-year, and exclude some of the largest companies like Google, Amazon, and Facebook.

NUMBER TWO, the Index is price-weighted. The problem here is that share price has nothing to do with how big a company is. So the companies with the highest share price (regardless of size) have more influence on the index. A company like Boeing ($318/share) has seven times the influence as Coca Cola ($46/share) and almost twice as much as Apple ($174/share). This isn’t right.

In the world of most investment professionals, the index du jour is the S&P 500. It tracks a broader group of stocks (505 to be exact), is weighted by market cap (so the largest companies have more influence), and measures most of the stock market’s value.

OK, we good? You realize the Dow has some serious flaws? Good. Thank you.

Now for some caveats.

NUMBER ONE, the Dow Jones has a rich history. It is the oldest index (started in the 1890s), it’s quoted everywhere, and it’s familiar. ‘The market’ and ‘The Dow’ have become synonymous with each other. It’s what we use in conversation. I wouldn’t want it to go away.

NUMBER TWO, the Dow Jones closely tracks to the S&P 500 over time, so perhaps I am wasting your time with pedantry where none is necessary (thanks Josh):

dow

To me, the Dow is like the pitcher win in baseball. Historically, the win was the common benchmark for things like Cy Young and Hall of Fame voting.

But over time, other stats emerged (WHIP, ERA+, FIP, WAR), and now we know that there are better ways to measure performance. But, like the Dow, I don’t want the win to go away. Even if it means nothing, there is something comforting about seeing a pitcher get to 15 or 20 wins.

And, admittedly, there is some comfort in seeing the Dow cross 25,000.

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