Why You Should Ignore the Dow Jones Index

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.

Comments

  1. Sunil from The Extra Money Blog says:

    i believe the recommendation is meant more from a “hedging” perspective – or from a simplistic approach to investing perspective. i do agree that the DJIndex is a good benchmark (though it can be enhanced as you said), but not critical by any means

  2. Mushroom Mike says:

    Greetings from Mississippi.

    I felt exactly the same way as you at one point. But then I changed my mind. For an index that only has 30 stocks, it actually does pretty well. Notwithstanding, your critiicisms are valid and there are other valid criticisms of it, that you do not mention. Thats why if you look at the Dow, and I do, it should not be the only thing you look at. Even in its earlier days it was not meant to be looked at in isolation. When we were more of a manufacuring economy (and not service orientated) the Dow 30 was meant to be looked at in conjuction with the Dow transportation index.

    One advantage of the Dow is that it has a higher volatility than the S&P. For some people this is not good, but for short term traders it is. Dont knock the Diamonds, some short term folk make good money trading it.

    If you want something to be annoyed about, rather get annoyed about the market commentary you hear each day:
    “Today the market went up/down because traders were doing this or traders were thinking that”. Journalists and newsrooms do not know the reason why markets have moved in whatever direction for the day. They should just say today the market went up/down, and not give the illusion that they know the reason why.

    :)

  3. Jon Stein, CEO of Betterment.com here. We’re helping busy people invest smart. I wanted to respond to your criticism of Diamonds in our portfolio.

    One of the things we do is pick a broad-based, diversified portfolio for our customers, one that’s like owning a little piece of every company in America. The Dow is part of that portfolio, and is weighted appropriately (10% of total) to pick up the right amount of exposure to those sectors, when balanced with our other holdings.

    To focus only on the Dow would be a mistake, we would agree with that. However, the downsides you mention don’t really apply to investors who hold this as one of many indexes in a diversified portfolio.

    When we add international stocks to our stock portfolio this month, we might eliminate Diamonds from the mix, and we’ll rely on other funds to capture that large-cap value piece of the market.

  4. For about four years until about a year ago, I had a roommate who was a day trader. As I am pretty much a Boglehead, you can imagine we had some interesting conversations on investing. One was about the use of the DJIA as the main index.

    I had made many of the same arguments you did in this post. It’s such a small number of stocks and it leaves out so many companies, why doesn’t the media use the S&P 500 or better yet a total market index as their main benchmark?

    “The Dow is a leading indicator,” he said, with a tone suggesting I was such a noob.

    I asked for clarification. “You mean to tell me the performance of the Dow gives you an indication how other companies you might invest in may perform in the near future?”

    “Yes,” he said with no hesitation.

    I’m not at all convinced. I believe the Dow was great back when it was invented, but now, with much more complete indices, means very little.

    It is nice, though, to provide comparison of the Dow today with say the Dow in the 1930s. We have more history with the Dow than other indices, so at least the Dow has that going for it.

  5. Nice post. I also agree, and get irritated every time I hear the DOW mentioned but not the S&P500.

  6. Jonathan, you are absolutely correct. Why Mr. Dow would choose to create a price-weighted average in the first place is mind-boggling. Even the “historical” aspect is flawed as the components change… most of the companies that were once part of the Dow have gone through bankruptcy losing most or all of their market value, or otherwise disappeared, so any semblace of conitnuity is just an illusion. For example, Bethelhem Steel, Hudson Motor, Nash, Studebaker, AIG, Woolworth’s, Johns-Manville, National Cash Register, Chrysler and yes, even General Motors

  7. @Warren – From what I understand, iIt was invented as a price-weighted average, because back in 1900 all this stuff had to be easy to calculate by hand. Calculators were rare and expensive for a while.

    @Jon Stein – Thank you for visiting my little corner and responding. Your idea is new and your portfolio is meant to be simple yet diversified in only a few select ETFs. Yet you add Diamonds (DIA) when every single company in the Dow is already included in (and a big chunk of) another ETF you hold, the Vanguard Total Stock Market ETF (VTI). On top of that, you have other value ETFs that also hold Dow components.

    I look forward to seeing the replacement of DIA with international exposure. I can see that you guys are thinking about it already, as I am not alone in my wishes.

  8. not to mention that the Dow drops underperforming companies, such as Kodak, GM, AIG. It’s an awful indicator of the overall U.S. stock market, despite the prominence that it gets in financial news.

    On the other hand, it’s not that bad of a investment. A DJIA ETF/mutual fund is still better diversified than a single stock.

  9. Saywhat says:

    All indexes are useless when it comes to perdicting the future of stock prices. They are a waste of time. They are a type of numerology. Numerology does not work.

  10. Rodrigo San says:

    Hi thank you for educated me on the DJIA I did not know that before reading this. That being said this article is incomplete. Now I need to know what to look at instead of the DJIA. Will you respond in a comment or in another article? Its important to know what to use now that I know the DOW has weaknesses. Thank You.

  11. Ron Eiger says:

    Im Confused.

  12. “That being said this article is incomplete. Now I need to know what to look at instead of the DJIA.”

    Good point. If you are looking for an unbiased, true indicator of the U.S. stock market, then look at the S&P 500, Wilshire 5000 Total Market Index, Russell 3000, or some other Total Market Index. The basic premise is that those indexes are much more objective and representative of the entire market. Whereas the Dow Jones 30 is completely handpicked.

    https://secure.wikimedia.org/wikipedia/en/wiki/List_of_stock_market_indices#United_States

  13. Rodrigo Says: says:

    Thank you Booky, i’m glad someone has posted this information.

  14. Here’s another article on “why Apple isn’t in the DOW”:

    http://www.bloomberg.com/news/.....-says.html

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