Why the Dow Makes Little Sense

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"The Dow." It's a presumed proxy of the entire stock market. But many of us don't fully appreciate what it really is -- and what its limitations are.

For starters, while the S&P 500 includes 500 big American companies, and "total stock market" indexes such as the Dow Jones Wilshire 5000 include several thousand, the Dow Jones Industrial Average features just 30.

That's just one of the Dow's shortcomings -- and these days, they're more pronounced than ever. Take the Dow's price-weighting, which means that the stocks in the index with higher prices carry greater weight in caluclating the overall average.

So with IBM (NYSE: IBM  ) recently trading around $90 per share and General Electric (NYSE: GE  ) trading around $12, IBM is more than seven times more influential in the Dow -- even though the companies' market capitalizations are both around $125 billion. The stocks that are really moving the Dow around carry the highest prices, such as ExxonMobil (NYSE: XOM  ) , Chevron (NYSE: CVX  ) , and McDonald's (NYSE: MCD  ) . Those with the lowest prices, such as Citigroup, which was recently trading around $3 per share, have almost no impact on it.

Meet the divisor
Let me back up a bit to give you a fuller picture. The Dow is essentially the average price of the 30 component stocks. That might seem kind of impossible, since most stock prices we pay attention to tend to be between, say, $5 and $200, and the index has recently been fluctuating around 8,000.

But if the companies in the index had never split their shares, issued dividends, or undergone major changes such as spinoffs or mergers during the time they were listed in the index, their average price would be around $8,000. Take component Coca-Cola (NYSE: KO  ) . In its 90-year history as a public company, if it had never once split its stock, one share would cost more than $200,000 today.

Similarly, Microsoft (NYSE: MSFT  ) went public in 1986, and it has since split its stock nine times. If you'd bought one single share when the stock debuted, it would have cost you less than $30. But, as of the time of this writing, that single share has become 288 shares, each worth about $17. Total it up, and that initial stake has grown to be worth roughly $5,000.

So how do we get from the current modest stock prices to the Dow's value around 8,000? Well, there's a little trick involved -- called the "divisor." It was recently 0.1255527090. The original divisor -- back in 1896, when the Dow was created -- was just the number of stocks in the average (12). However, to account for stock splits, mergers, and such, the divisor has to be adjusted frequently. (A few years ago, it was 0.14452124.)

Take a component's stock price, divide it by the divisor, and you'll see how many Dow points it represents. Coca-Cola, for example, recently traded near $43, which works out to 342 points in the Dow.

Weird effects
A recent study by Bianco Research noted that financial companies' recent low prices mean those stocks have ceased to have much effect on the Dow. With many financials trading under $10 per share, the Dow would only lose a few hundred points, even if all of them fell to zero.

In addition, there's a good chance that some Dow stocks with Lilliputian prices will get booted out of the index in the near future, because the Dow typically frowns on stocks with prices below $10. When that happens, and the companies are replaced, we can expect the index's dynamic to change -- again.

So what?
Well, as you take the pulse of the market in this volatile but exciting time, don't pay too much attention to the Dow. When you see how it's changing from day to day, it's really only telling you how a few stocks have performed.

Also, know that there are other ways to build indexes, other than weighting components by stock price, which usually doesn't tell you too much by itself. The S&P 500 index, for example, is a market-cap-weighted index, giving the companies with the greatest market values the most influence.

Bargains? In the Dow? You'd be surprised:

Longtime Fool contributor Selena Maranjian owns shares of Coca-Cola, Microsoft, General Electric, and McDonald's. Coca-Cola and Microsoft are Motley Fool Inside Value picks. Try our investing newsletters free for 30 days. The Motley Fool is Fools writing for Fools.

Read/Post Comments (4) | Recommend This Article (19)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 02, 2009, at 11:56 PM, JohnEBgood wrote:

    I understand and agree with much of what you said.

    But I'd like to point out a few things. First of all

    performance of the Dow over the past 5 yrs has been

    pretty close to that of the S&P 500.

    Over the past year, however, the DOW has outperformed

    the S&P 500, and the dividend yield is higher (3.35 vs 3.02%)

    I’ll agree that weighting according to the price of the stocks is irrational. But I’m not sure that weighting according to market cap is ideal, because the largest companies might be less able to grow.

    Disclosure: I’ve been accumulating some shares of DIA.

    In spite of the shortcomings of this index, it is one way to

    play a certain sector of the market.

    And anyway, some have argued that the total stock

    market “makes little sense”…..or at least it’s easy to feel

    that way when things keep going down, down, down ;o)


  • Report this Comment On February 03, 2009, at 8:18 AM, pondee619 wrote:

    Are you now editing for Rick?

    1/28/09 He wrote a very similar article. At least your point was the same.

    BTW doesn't the Dow accurately reflect the market as well as any other index? If so, why change it?

  • Report this Comment On February 03, 2009, at 10:33 AM, SteveTheInvestor wrote:

    The Dow also includes Bank of America... another god-awful stock. If the Dow was weighted equally by each of the 30 companies, it would be much lower than it is now. Unless I'm missing something here, it seems to me that the index is artificially inflated.

  • Report this Comment On February 04, 2009, at 9:42 AM, cheeseburgerbob wrote:

    Thank you for writing this! Now if the mass media would only know what or why they are "reporting" on things maybe we could become a little less focused on "the market" in every business related story or headline. I cringe every time I hear a "breaking now!" update and hear/see the quick shot of "what the market is now". It is indicitive of not knowing what we are investing in, signing, committing to, voting on or for and an excellent reason we are crowned as the short-term, shallow culture. As a great song goes "get over it" Maybe The Fool can assist the business-impaired in the mass media to provide real journalism vs sensational, but misleading and shallow headlines...

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