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Pay Less Attention to the Dow

Cisco (NASDAQ: CSCO  ) is having a great year. Its stock is up 33%, trouncing the rest of the market.

But Cisco's success hasn't been much help to the Dow Jones Industrial Average, where it's one of 30 components. Because the Dow weights its 30 holdings by share price, and Cisco has a relatively low share price, it makes up just over 1% of the index's weight. Its blistering outperformance has added less than half a percentage point to the Dow's gain this year.

Chevron (NYSE: CVX  ) is having a mediocre year. Its shares are up about 13%, trailing the overall market. But because it has a high share price, it makes up more than 6% of the Dow. Its underperformance has added eight-tenths of a point to the Dow's returns, or more than double the share of Cisco for one-third the return.

Every index needs to weight its components. Some weight them all equally. Others, like the S&P 500, weight by market cap. The Dow does it the most curious way possible: by share price, which has no relation to a company's size, value, or relevance.

This causes big skews between how individual Dow components have performed and their contribution to the Dow's return:

Source: S&P Capital IQ, author's calculations.

Last year I asked Rob Arnott, a pioneer of alternative forms of index investing, why the Dow uses such a funny weighting. He replied:

Weighing 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'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 forfend, Berkshire Hathaway in the Dow index. If you had Berkshire Hathaway in the Dow, it would be the Berkshire Hathaway Index.

Few would argue that Travelers (NYSE: TRV  ) is more reflective of the American economy than, say, Apple (NASDAQ: AAPL  ) . But Apple will never be allowed into the Dow without splitting its stock several times. Think about this, and the Dow's components aren't based on relevant companies that should be there, but on 19th-century mathematical constraints. 

People like to say the stock market doesn't reflect the economy. As a corollary, the Dow doesn't always reflect the stock market. 

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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 August 10, 2013, at 1:34 PM, somethingnew wrote:

    Thank you for explaining this. I've always wondered how the dow is weighted.

  • Report this Comment On August 10, 2013, at 5:45 PM, lowmaple wrote:

    Interesting as usual. But if you want to nit pik Dividing by 10 is simpler. (If I nit pik my post I don't know if this term is one or two words)

  • Report this Comment On August 12, 2013, at 10:37 AM, XXF wrote:

    I agree that share price weighting is a silly way to weight an oft reported index, but I disagree that to make it more relevant we should pack it full of hot tech companies. Look at AAPL's history as an organization and tell me that it represents the US economy at large. In the last 10 years it's market cap has varied from $5B to $605B.

    Additionally, although the DJIA is price weighted it has tracked remarkably similarly to the overall market over the course of time, and even closer to large cap, cap weighted indexes. While there are probably events that could mess up the historic correlation we haven't seen any in 120 years, so there is an additional element of "If it ain't broke, don't fix it" in the rationale to leave the DJIA as is.

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