Millions of Americans never look beyond the Dow Jones Industrial Average (DJINDICES: ^DJI ) in thinking about the stock market. With all the news that its streak of eight consecutive all-time record-high closes generated over the past two weeks, the Dow has only cemented its status as the center of attention for mainstream investors and market observers.
Yet what most of those people don't know is that the Dow has largely become irrelevant as a true measure of the market's health. Despite the Dow's more than 100-year history, it gets far more attention than it deserves, overshadowing other market measures that carry more useful information about stocks and their financial health. Let's look at five reasons you should stop paying so much attention to the Dow.
Reason 1: The Dow has only 30 stocks.
In a market with thousands of different companies covering the widest swath of industries, company sizes, and geographic areas, the Dow has room for only 30 of them. The folks who manage the Dow do their best to pick the most deserving candidates, but with such a limited number of spots available -- as well as a tendency not to want to make changes unless it becomes absolutely necessary -- the Dow's ability to stay relevant comes under assault all the time.
Reason 2: Out of the Dow's 30 stocks, only a few really matter.
Because of the way the Dow is calculated, only the stocks with the highest share prices really have a big influence on the overall average. Consider: IBM (NYSE: IBM ) shares are worth 17 times what a share of Bank of America (NYSE: BAC ) costs. As a result, when you look at the gain of about 7% that IBM has enjoyed so far in March, IBM has contributed more to the total number of points that the overall Dow has risen than Bank of America throughout its rise of more than 150% from December 2011 through yesterday. Put another way, a 1% move in IBM moves the Dow by more than 16 points, while the same 1% move in B of A has less than a 1-point impact on the Dow.
Reason 3: The Dow leaves out essential companies.
Have you ever wondered why Apple and Google are left out of the Dow? Apple has the largest market cap in the U.S. market, yet most experts agree that the company will never get into the Dow unless it takes the step of splitting its shares. The reason: With a stock price above $400 per share, Apple would have twice the importance even of IBM, dominating the Dow. For its part, Google would have still more weight, with its $800 share price giving it about a third of the overall influence in the Dow.
You can also make similar arguments about corporate leaders in industries that get left out of the Dow. For instance, since the ejection of General Motors (NYSE: GM ) , the Dow hasn't had an automaker among its ranks, despite the clear importance of the auto industry to the overall economy. Such omissions threaten the Dow's relevance and credibility.
Reason 4: The Dow has bad timing when its managers make changes.
The Dow doesn't make many changes, but when it does, it has had some terrible timing. Among some of the worst examples were the decision to wait until after the financial crisis to replace Citigroup and GM, with GM on the brink of bankruptcy when it was replaced in June 2009. Similarly, AIG (NYSE: AIG ) didn't get replaced until September 2008, after it had already suffered huge losses in advance of its needing a massive federal bailout. On the other hand, the additions of Microsoft and Intel in November 1999 corresponded almost perfectly with the high-water mark of the tech boom, with both companies suffering severe losses in the ensuing bear market.
Reason 5: The Dow leaves out international companies.
The Dow includes only U.S. companies. That made sense when the U.S. was the dominant capitalist economic power in the world, but with up-and-coming international markets catching up to the U.S., the Dow can no longer claim to track well with stock markets around the world. Although many of those companies have businesses with global scope, many foreign companies are world leaders in their industries, leaving the corresponding Dow component in that industry as an also-ran at best.
Go beyond the Dow
The Dow is a perfectly reasonable way to measure how some of the top companies in the U.S. are performing in the stock market. But as a reflection of the entire stock market, it falls woefully short. That's why you shouldn't obsess over the Dow's every move, instead taking a big-picture perspective on the broader market.
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