9/28/12

"So, what did the market do today?"

When people ask that question, most likely they are talking about the Dow Jones Industrial Average. Our minds consciously flip to it anytime there is market news; heck, we even articulate our views on the markets in terms of this index: "Dow's going to zero. Dow's going to 20,000. Dow is staying put."

But how often have you heard: "It doesn't matter what level it's at, the Dow is a crappy price-weighted index that nobody should be paying attention to in the first place."

If you're a reader of Ken Fisher's Forbes columns, you have. If you aren't, you're probably doing a double take.

How could the Dow be useless, you ask? It's the single most followed and commented-upon index in the world!

Here's why:

1. It's only about 29% of total US market cap.

There are only 30 (admittedly very big) stocks in the DJIA, amounting to only about 29% of total US market cap. Thirty. That's it! At least the S&P500 has around 89% of total US market cap. How do they even choose the stocks included in the index, exactly? Microsoft is in, but no Apple? No Google? Some doctors need to look into this.

2. It's price weighted. This is beyond stupid. If you answered "yes" to an interviewer's question on whether a company's stock price is the best indicator for its inclusion in the world's most-closely-watched market index, you'd be laughed out of the room. Stock price alone is not an indication of the company's quality or profitability, but that's how the Dow is structured. For example, Dow member 3M (MMM) closed today (Sept. 24) at $93.73 per share. Fellow Dow stock Microsoft closed that day at $30.78 per share. That means 3M has three times as much of an impact on the Dow as Microsoft, even though the latter has a much larger market cap. It makes no sense. It would make more sense to weight the index by market size, not stock price, which is arbitrary and distorts the weighting.

3. Stock splits cause all kinds of trouble for the Dow. A stock split doesn't change anything fundamental about a company. The size of an investors' position doesn't change in the event of a stock split, just the number of shares. But because the Dow is price-weighted, stock splits among companies with a higher share price have a bigger effect on the overall index. If a large company like Coca-Cola orders a 2-for-1 split for example, (as it recently did), that's going to have an impact on the Dow in a negative way even though nothing fundamental has changed about the Coca-Cola company.

And this isn't just the Dow--the Nikkei has the same wacky price-weighting built into it.

Let's all do ourselves a favor and use the S&P500 instead!

Comments (19)

9/25/12
9/25/12

besides ignorance and consumers being accustomed to it, why does the mainstream media still report the Dow #'s at the top of business/financial news every day?

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9/25/12

because a 500 point drop for the dow sounds a hell of a lot worse to the non-finance population than 55 points when you're talking about the s&p. the media uses it for sensationalism, nothing new there

9/25/12

4. Replacing Dow companies messes things up even further.

I've been saying this for years. The S&P 500 is the only index I watch on a daily basis. Any suggestions for what should be the Dow's replacement? The S&P has many of the same weaknesses.

9/25/12

i never understood price-weighted indices... could there be a legitimate reason to weigh an index like that other than pure laziness? i can't think of any...

Money Never Sleeps? More like Money Never SUCKS amirite?!?!?!?

9/25/12

Don't get the first point, 30 stocks representing 29% market share, meaning large enough companies where as little bits of idiosyncratic news/ headline risk have minimal impact on that specific stocks needle, where as one piece of news can cause a stock within the 500 or Nasdaq to swing 10% one way or the other, thus why its a great MACRO indicator, and that's all you need when you look at market activity....MACRO conditions.

In reply to sayandarula
9/25/12
sayandarula:

i never understood price-weighted indices... could there be a legitimate reason to weigh an index like that other than pure laziness? i can't think of any...

Fisher thinks it's basically just out of tradition, and the Dow owned the WSJ for a very long time...probably has something to do with it.

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9/25/12

best is to look at treasury rates but the average joe gets scared by the word bases points

9/25/12

I have three more reasons: friday, monday, and today

9/25/12

Does anyone else feel that either CNBC is condescending, or they are just idiots? Their "statistics" and obvious political views really make them look bad.

In reply to entourage
9/25/12
entourage:

Don't get the first point, 30 stocks representing 29% market share, meaning large enough companies where as little bits of idiosyncratic news/ headline risk have minimal impact on that specific stocks needle, where as one piece of news can cause a stock within the 500 or Nasdaq to swing 10% one way or the other, thus why its a great MACRO indicator, and that's all you need when you look at market activity....MACRO conditions.

Can't tell if this is serious...

"We are buried beneath the weight of information, which is being confused with knowledge; quantity is being confused with abundance and wealth with happiness. We are monkeys with money and guns." - Tom Waits

9/25/12

I could talk for a while on this.

Google was rumored to be joining the DJIA a few years ago. I'm not sure how that would have worked given it's PPS...Also whatever happened to the Industrial part of the average???

The DJIA is a shitty market barometer of the entire US market, but it exists because 99% of the US is completely retarded when it comes to finance and for what it's worth, it works. It's the one index that the common person understands relative to the performance of the market. Most people have an idea of good and bad levels of the DJIA. I've tried to introduce my friends to the S&P, but conversations generally go like this:

Me: The S&P is at 1,400
Friend: Is that bad?? OMG. The market is doing terrible!!!
Me: I believe you're thinking of the Dow which is over 13,000.
Friend: Cool. Why should I care about this S&P thing?
Me: Never mind. Buy apple.

9/25/12

I don't pay any attention to the Dow. I look at the s&p and most of the sector etfs/indexes.

The market is very big. Look at one index, and you're getting a very distorted picture.

Because when you're in a room full of smart people, smart suddenly doesn't matter--interesting is what matters.

9/26/12

Another thing that I may add to the list is that the components of the Dow are changing all the time. This means that when you look at how the Dow Jones has increased over a decade, you have to know that the Dow 5, 10 years ago was very different from now. Different companies. So it is somewhat irrelevant to compare the current Dow to 10 years ago.

In reply to sayandarula
9/26/12
sayandarula:

i never understood price-weighted indices... could there be a legitimate reason to weigh an index like that other than pure laziness? i can't think of any...

Because you could calculate it on a chalkboard 90 years ago. So, yes....laziness (and tradition, I guess).

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In reply to SirTradesaLot
9/26/12
SirTradesaLot:
sayandarula:

i never understood price-weighted indices... could there be a legitimate reason to weigh an index like that other than pure laziness? i can't think of any...

Because you could calculate it on a chalkboard 90 years ago. So, yes....laziness (and tradition, I guess).

right... i was thinking that too. back before computers and such people could calculate the DJIA rather quickly, which was important. we probably use it today as a legacy of older times...

Money Never Sleeps? More like Money Never SUCKS amirite?!?!?!?

9/26/12

The concept of market capitalization probably didn't come into existence for a while so you could really only have a price weighted or equal weighted index. Prices were the simplest thing to go from.

9/29/12

4.) It's the only index that goes back before 1950 (besides the Dow Railroads Index

5.) It's a real investment basket and does track some sort of diversified large cap equity index.

6.) A lot of economic research, including a lot of stuff you learned in college and what most traders believe about the market, depends on research done on the DJIA on some level.

Like it or not, kooky index system or no, the dow jones is here to stay.

9/29/12

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