Whenever you hear a stock market update on TV or even online, it’s usually related to the Dow Jones Industrial Average (DJIA)… “The Dow went up 100 points today.” “We are pushing back towards Dow 14,000!” I never really thought about this until reading in my current nightstand-book All About Index Funds that the Dow, started in 1896, has quite a number of flaws as compared to other newer indexes. These flaws are well described in this academic paper The Dow Jones Industrial Average: The Impact of Fixing Its Flaws. Here’s a quick summary:
#1 – The Dow only includes 30 somewhat-arbitrary stocks
In 1896, the DJIA had 12 stocks. In 1916, it grew to 20. In 1928, it increased again to 30. That’s it. It’s still just 30 stocks almost 80 years later. Not only that, but it’s not even clearly defined as the largest 30 companies or something like that. It’s simply 30 companies chosen by a committee to best represent the market out of the ~5,800 readily-priced publicly traded companies out there. Certain major sectors like transportation and utilities aren’t even covered.
#2 – The Dow is a price-weighted index
The DJIA is not weighted according to the relative value of the companies like the S&P 500 is. Instead, it’s weighted by price. So if GE’s share price of $41 goes up by $1 (market value change of ~$10 billion) , it can be negated by a $1 decrease in 3M share price of $92 (a market value change of ~$700 million). This skews the average towards the activity of higher-priced stocks.
#3 – The Dow doesn’t include dividends
This flaw is common to all of the other major stock indexes ? S&P 500, Nasdaq, Wilshire 5000. But given the relatively large amount of dividends that the companies in the Dow has historically paid out, this is important. The paper found that a total return index of the Dow companies including reinvested dividends would make the value of the index to be over 250,000 points today. Other indexes, like the Nasdaq, pay out a very small percentage in dividends in comparison.
Most surprisingly, the paper also concludes that #1 and #2 haven’t actually made that that much difference when comparing long-term returns with the other major indexes. Add in all that tradition, and I guess we’ll be seeing the Dow stick around for a long time to come.
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It makes you wonder why some people would invest in an index fund that tracks an index that they don’t even know how it works.
It is definitely not an accurate index for judging the health of the United States economy. As many American students in colleges believe just because the DJIA hits a new record, the U.S. is doing great. Absolutely incorrect. There are many foreign companies listed on this index.
It sounds foolish when Americans quote the Dow as an indicator of health of the U.S. economy.
P.S. Jonathan, I am suggesting a topic for your blog– How the United States is increasingly becoming an importer of goods rather than an export base economy and how it will affect U.S. consumers in the long-run. You will find some scary quantitative and qualitative information. In my opinion, this topic needs to be addressed before the average American consumer berates China.
The Dow is popular just because it’s been around for a long time. Real money professionals ignore it pretty much.
Regarding Kevin Spring’s comment:
1. Lots of people know the Dow is a poor index and advisors regularly avoid it in favor of the S&P 500.
2. People buy stuff based on historical trends and the sense of stability. There are dozens of “rules” about the US economy (or Dow) that are true from a rear-view mirror perspective and that enough for some people. Of course this often leads to mistakes and is a bad strategy.
3. If you know and like the particular stocks in the Dow you can place a cheap bet on their performance through the index.
4. Since when did most investors make good decisions?
Here was my hint; Dow plunges hundreds of points day after day, my stock portfolio decreased by maybe 1%. I quickly realized that I don’t need to freak out when the Dow has rainy days.
Makes you wonder about strategies such as the Dogs of the Dow. If the companies really are that arbitrary then that it certainly would call the strategy into question even more so than it already is.
I agree with one of the other comments – the dow is largely ignored by money managers as a proxy for results. However, there is no denying how well it has done as an index!
imho, if your savings surplus was placed in a DJIA index fund instead of a safehaven money market or savings or CD, then you wouldve had much better returns on your $’s.
Kristofer
“Dow plunges hundreds of points day after day, my stock portfolio decreased by maybe 1%”
If the DJIA drops 130 points, that is approximately 1%…It’s the same thing that’s happening in your portfolio.
However, if the DJIA drops 1000 points and all you lose is 1%…you’re way to heavy in other investments.
Shak…when was the US ever export-based outside of agriculture?
“Never say dow!”
Instead use the S&P 500, it is cap weighted!
“However, if the DJIA drops 1000 points and all you lose is 1%?you?re way to heavy in other investments.”
I think many people would’ve liked to have had my portfolio during that plunge, I do not regret a single investment. So while I may be invested heavily in other investments, I’ll venture to say that just because I didn’t lose anything in the DJIA plunge I wouldn’t say “Too heavily.” I’m one of the few in my little investment group who’s out performing all major indices.
I would like to know what makes the dow go up or down x amount of points. exe: the dow went up 100 points! Co in the dow ave. gain to day; IBM went up 0.52, GM went up 1.05, BOING went down 1.99. where did the 100 points come from?