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.