The Dow: A Deeply Flawed Index

The Dow Jones (DJINDICES: ^DJI  ) is one of the most popular indexes in the world. It's also one of the most ill-conceived.

Why? Because the Dow weights its 30 components by share price, not market capitalization, creating some weird skews that defy logic. IBM (NYSE: IBM  ) commands more than 11% of the Dow, while Bank of America (NYSE: BAC  ) makes up 0.6%, even though IBM is only about twice the size of B of A. Some have pointed out that if Apple (NASDAQ: AAPL  ) became a Dow component, its high share price would utterly dominate the entire index, even though other companies such as ExxonMobil (NYSE: XOM  ) are nearly as big.

Two weeks ago, I sat down with Robert Arnott, CEO of Research Affiliates and one of the nation's experts on index investing. I asked him about the history of the Dow's flaws. Here's what he had to say (transcript follows):

Robert Arnott: The Dow has been around for over a hundred years. It's showing signs of age, but it's going to go up and down with the market. If you look at the correlation of the Dow with the S&P, it's a very high correlation. It's a well-diversified portfolio of 30 stocks. It's a deeply flawed index, but if you're interested in whether the market went up or down today or up or down this month or this year, you can use it for that purpose. As a strategy, no.

The rationale for weighting the Dow by share price goes back to quill pens in the 1890s. If prices were quoted and came across on a telegraph wire very slowly, and you had to write down the numbers, what could be easier? It started out as, I think 12, companies, 12 big blue-chip companies. What could be easier than to add the 12 up? There weren't calculators -- let me rephrase that. There were calculators; they were human beings whose job was to calculate. Calculators would add up the 12, divide by 12. It goes back to the quill pen days. It's the simplest way to construct an index if you don't have a computer. It's kind of irrelevant today.

It's the reason that you don't have Google or Apple or, heaven forbid, Berkshire Hathaway in the Dow index. If you had Berkshire Hathaway in the Dow, it would be the Berkshire Hathaway Index.

link


Read/Post Comments (3) | Recommend This Article (4)

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 December 21, 2012, at 7:11 PM, ligett wrote:

    1) The S&P is good

    2) The Dow is bad

    3) The two are extremely well correlated

    How can all 3 be true?

  • Report this Comment On December 21, 2012, at 7:32 PM, NOTvuffett wrote:

    You could also say the NASDAQ is flawed because it is tech heavy, many days it moves in a direction opposite to the DOW and S&P. What would be the ideal index, one with all equities that one could buy from any exchange in the world? How would it be weighted?

    Although DOW may be a blunt instrument, it is pretty good, S&P better, and diminishing returns from there.

  • Report this Comment On December 22, 2012, at 7:28 AM, TMFMorgan wrote:

    ligett,

    The S&P is better, but not great, in my opinion. Arnott's important point is that both can be good for tracking markets, but not necessarily for investing in them.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2166537, ~/Articles/ArticleHandler.aspx, 12/18/2014 10:46:18 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Apple's next smart device (warning, it may shock you

Apple recently recruited a secret-development "dream team" to guarantee its newest smart device was kept hidden from the public for as long as possible. But the secret is out. In fact, ABI Research predicts 485 million of this type of device will be sold per year. But one small company makes Apple's gadget possible. And its stock price has nearly unlimited room to run for early-in-the-know investors. To be one of them, and see Apple's newest smart gizmo, just click here!


Advertisement