The Dow Jones Industrial Average (DJIA) is an antiquated, somewhat-arbitrary, poorly constructed, incomplete indicator that does a subpar job of tracking the actual performance of the U.S. stock market. There, I said it. Every time I see it mentioned in the financial media down to the decimal points like it’s some hyper-accurate holy number, I get a bit annoyed.
A recent BusinessWeek article Why Apple Isn’t in the Dow served as another reminder of why I feel this way. Whether or not you like Apple, it’s the second largest company by market value in the country. Is it in the Dow Jones? Nope. Why not?
The Dow only includes 30 stocks, picked by WSJ editors. In 1896, the DJIA had 12 stocks. In 1916, it grew to 20. In 1928, it increased again to 30. It’s still just 30 stocks over 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 publicly traded companies out there. As a result, new companies like Microsoft, Intel, and now Apple are added rather late, and major sectors like transportation and utilities aren’t even represented.
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 or other “Total Market” indexes. Instead, it’s weighted by share price, something that is very arbitrary. The same company could have a million shares at $10 each, or 1,000 shares at $10,000 each. It’s worth the same, but the second company would have 1,000x the effect on the Dow Jones Index. This means Apple stock (about $330) would have the 18 times the effect of General Electric, even though it’s market value is only about 1.5 times more.
This also means you shouldn’t invest in any mutual funds or ETFs that follow the Dow either. I’m looking at you “Diamond”, the SPDR Dow Jones Industrial Average ETF (ticker DIA). By extension, this is also one of my problems with the investing start-up Betterment.com. I would never take advice from a financial planner that said a Dow Jones ETF was a critical part of my portfolio’s asset allocation.
By Jonathan Ping | Investing | 6/27/11, 1:38am