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This article is part of our Better Investor series, in which The Motley Fool goes back to basics to help you improve your returns and be more successful with your investing.
Millions of ordinary people know more about the Dow Jones Industrial Average (INDEX: ^DJI) than any other market measure. But as a way of gauging the health of the U.S. stock market, the Dow has huge flaws that make it almost a useless measure.
An apple a day
Earlier this week, Bespoke Investment Group pondered the possibility of adding Apple (Nasdaq: AAPL ) to the Dow. It's easy to understand why the move would have broad-based appeal, as Apple has flirted with the status of the nation's largest stock by market cap.
There's little doubt that Apple deserves recognition as one of the most important U.S. companies, given its dominant influence on technology in the last decade. But as Bespoke pointed out, the move would have a huge effect on the Dow. Because Apple's share price is more than $400, the stock would have a mammoth 22% weighting in the average. Therefore, Bespoke concluded, unless the iDevice giant were to agree to a share split -- something it hasn't done since 2005 -- it wouldn't be feasible to include the stock among the Dow 30.
Simple gauge or outdated relic?
On its face, the Dow seems like a simple yet efficient way to look at the market's overall health. Encompassing 30 stock choices from a variety of important sectors of the economy, the Dow Industrials now go well beyond traditional industrial stocks to include financials, health care, retail, and even fast food. And the ease of adding up all of the share prices of the Dow's components and then dividing by a common factor to come up with the average's value couldn't be easier.
But the Dow's simplicity also creates some disparities between it and other common market measures like the S&P 500. The biggest is the fact that companies with the highest share prices have the most weight in the index even if their overall size doesn't match up with its share-price ranking. For instance, right now, IBM (NYSE: IBM ) has by far the largest weight in the Dow, making up more than 11% of its value. Even when you add up the nine components with the smallest weights in the Dow, they still have a smaller combined effect on the average than IBM does -- even though those nine stocks include Microsoft (Nasdaq: MSFT ) , which has a larger market cap and greater net income than IBM.
Other disparities make themselves felt within sectors. ExxonMobil (NYSE: XOM ) is far larger than Chevron (NYSE: CVX ) by every financial measure, including revenue, profit, and market cap. Yet Chevron trades at about $100 per share while Exxon is stuck at $75, so Chevron has a bigger effect on the Dow's overall moves. The same holds true for the larger, lower-priced Pfizer (NYSE: PFE ) versus the smaller Merck (NYSE: MRK ) and its more expensive shares.
All the wrong moves
In addition, the Dow has made some bad missteps in its decisions to make changes to its lineup of companies. It admitted Microsoft just as the tech bubble was nearing its top, and added AIG during its heyday in 2004 -- only a few short years before its near-total collapse. Its timing was even worse when it added Bank of America in 2008, just before the worst of the financial crisis struck.
Of course, not every move the Dow has made has been bad. And even in its bad calls, the Dow is hardly alone. The S&P 500 has also made some big miscues in its timing of adding and deleting companies from the benchmark.
But combined with the more mathematical problems associated with the average, the Dow is a dubious measure of the health of the overall stock market. Despite the Dow's historical significance, you'll do better tracking individually the stocks that make up the average -- as well as others that can fill your portfolio to give it the diversification you need.
Several Dow components pay big dividends right now. To see them and other attractive dividend stocks, be sure to check out the Fool's free special report, "13 High-Yielding Stocks to Buy Today."
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Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter here.