The Dow Is Worthless

The Dow Jones Industrial Average (INDEX: ^DJI  ) is the most widely quoted measure of the U.S. stock market, yet it is terrible at its job. Read along and I'll explain why the Dow is a poor measure of the U.S. market. I'll also share a surprising stat that might change your mind on the state of the U.S. market and tell you how you can profit from all this.

The Dow
The Dow Jones Industrial Average is an index of just 30 stocks whose stated goal is "to provide a clear, straightforward view of the stock market and, by extension, the U.S. economy." Started in 1896 by financial journalist Charles Dow, the Dow is weighted by the stock prices of its component companies and nothing else. To calculate, you simply add up the 30 stock prices and divide the total by the Dow Divisor. When the index was formed, the divisor was 30, but after 116 years of stock splits, dividend payments, and component changes, it currently stands at 0.132129493.

This method is a relic of the pen-and-paper times the Dow was invented in, when it was much too complicated to use the more rigorous methodologies of the S&P 500 or the Wilshire 5000. The simplistic weighting has led to ridiculousness such that IBM has more than twice the effect of ExxonMobil on the Dow, even though Exxon is nearly twice its size. The outsized effect of just a few stocks is a major problem, as many people's perception of the state of the U.S. economy is based on the Dow.

The state of the market
After a crazy 2011, the Dow has been trending slowly upward and currently sits just barely above its 2008 level.

Dow Jones Industrials Stock Chart

Dow Jones Industrials Stock Chart by YCharts

But is this truly the state of the market? In the late spring of 2009, Dow component General Motors (NYSE: GM  ) was on its way to bankruptcy, which meant it would have to be taken out of the index. Many people expected GM to be replaced with Apple (Nasdaq: AAPL  ) , as it was a tech bellwether. Instead, the Dow powers-that-be ended up choosing Cisco (Nasdaq: CSCO  ) in June 2009, and that's how we have the Dow as we know it today.

The Dow that didn't happen
It's interesting to consider what could have been. Apple has been on a tear the past few years and has become the largest publicly traded company in the United States. Bespoke Investment Group crunched the data on what the Dow's performance would look like if Apple had been included instead of Cisco.

Source: Bespoke Investment Group.

Imagine how the market itself would be different had Apple been included. A few months ago, the Dow would have broken its all-time high of 14,164 and as of early February would have been at 14,636! Pundits would be screaming about how it is such a great time to invest. Dow Soars Above 14,000! Dow at an All-Time High! Dow 15,000! Companies would be hiring more people and buying back stock in droves as confidence grew with the rising stock prices.

Yet the fact that the Dow can be altered so heavily by just one stock is exactly why you shouldn't rely on the Dow. It's not just Apple that would have changed the Dow so mightily, either. The index also would have been way up had Ford (up 116%) or Amazon.com (up 140%) been included in place of General Motors since June 2009.

Bottom line
People pay attention to the Dow out of habit, as Dow Jones itself explains on its website:

The Dow Jones Industrial Average is the most-quoted market indicator in newspapers, on television, and on the Internet. Because of its longevity, it became the first to be quoted by other publications. This practice became habit when Wall Street earned at least a mention in the general news each day, and habit became tradition when the post-World War II bull market commanded the nation's attention. The Industrial Average became the indicator to cite if you were citing only one.

Like cursive writing, the imperial measurement system (how many inches are in a mile again?), the QWERTY keyboard, and other terrible ideas we continue to use just out of habit, the Dow should be phased out of existence. There are better measures out there of the state of the market, like the S&P 500, that are less prone to the swings of just a few stocks.

Watching the market every day is exciting but also gut-wrenching and stressful. Forget the Dow, and focus on companies that will crush it over the next 10, 20, 30 years and invest for the long term. If you are looking for long-term investing ideas, The Motley Fool has created a brand-new free report: "3 American Companies Set to Dominate the World." Get access to the report and find out the name of these legendary companies. The report is free, but it won't be forever, so check it out today.

Fool contributor Dan Dzombak owns shares of Cisco Systems, but he holds no other position in any company mentioned. Like his Facebook page to follow his investing articles. The Motley Fool owns shares of Apple, Ford, Amazon.com, and Cisco Systems. Motley Fool newsletter services have recommended buying shares of Apple, Amazon.com, Ford, ExxonMobil, and General Motors, creating a bull call spread position in Apple, and creating a synthetic long position in Ford. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On March 19, 2012, at 10:36 AM, hohocake wrote:

    Here's a mystery question I never quite got: With all the modern computing power we have now why isn't there a metric for the entire market? A composite index of the changes in value of all public stocks?

    I mean, S&P is nice but doesn't that tell less of a story than the actual also? Better than the DOW, worse than the actual?

    Or in other words, what is the total market cap of all US traded stocks combined vs. the market cap of the S&P? What % margin of error is created by that? I'm all for there being a variety of indexes so you can see, in the S&P case, how broad wide caps did or a transit index for transport stocks, but the one that seems missing is a broad index of the entire market.

  • Report this Comment On March 19, 2012, at 11:50 AM, sikiliza wrote:

    I agree with the assertion that the Dow may not accurately reflect the market level "when compared with the actual level had the composition been different".

    That being said, your argument about including CISCO rather than Apple could be used pretty much for any of the 30 other constituents of the index. I think the biggest issue with the Dow is that it doesn't accurately reflect the current composition of economic growth and consumption thereby rendering it less than ideal for purposes of gauging the true trends in the economy and on the markets. Additionally, the composition of the Dow has changed a great deal over time rendering it less than ideal for market analysis due to survivorship bias. Does this mean that it doesn't reflect the overall trend of the market? I would think not since the Dow Theory although almost defunct is still very much in play.

    As a result, inasmuch as I watch all three indexes for indications of wider market trends, I have over time created a quasi-portfolio of sector ETFs covering ten major sectors, which gives me more insight and information as to how the different sectors are performing by themselves, and in relation to the market in general.

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