Why Do We Watch the Dow Jones So Closely When its Makeup Makes No Sense?

Weighting components by price can lead to all sorts of problems when you're not watching the right stocks.

Jul 23, 2014 at 4:30PM

The Dow Jones Industrial Average (DJINDICES:^DJI) is a strange beast. With only 30 components, it can't possibly represent the scope of American stock markets as well as the broader S&P 500. Yet not only does the Dow follow the S&P fairly closely in any given year, it has actually outperformed the S&P on a longer timeline. No matter how much we might claim that the S&P is more accurate, it's still the Dow that we look to every day. After all, since it has 30 of the most popular stocks on the market, most investors probably have a stake in the Dow's performance. And since it only tracks 30 stocks, it's easier to figure out why the index moved in any direction on any given day.

But how much do the Dow's components really matter? Think about it -- right now, six financial companies account for more than a quarter of the Dow's daily momentum. Six tech and telecom companies, which together account for nearly three times as much market value as the six financial stocks, have less than half as much influence on the index's movements. To see how strange the Dow's share price-weighting scheme can really get, let's examine a few possible changes that might make sense for the blue-chip index, but would be almost incomprehensible in a weighting scheme like the S&P's where size matters most.

The retail switcheroo
Wal-Mart (NYSE: WMT) is by far the world's largest retailer, and it's also the Dow's sixth-largest component by market cap. But its share price keeps Wal-Mart in the lower third of Dow components by weight. We could swap it with Costco (NASDAQ:COST):


with Wal-Mart

with Costco

Dow component weight



Dow sector (retail) weight



Component weight on S&P 500



Market cap vs. replacement



Sources: Finviz, Yahoo! Finance, SlickCharts.

Replacing Wal-Mart with Costco would boost the retail sector's representation, but retail is already a bit over-represented relative to its actual economic weight in the United States. It would also make the Dow more representative of the lifestyles of its investors -- the average Costco shopper has a household income of $85,000, while 20% of Wal-Mart's customers are on food stamps. But the Dow is supposed to represent the entire economy, not just the part preferred by the investing class. Costco, in fact, has a lower market cap than any of the seven retail-oriented stocks currently on the Dow.

Connecting the Dow to the cloud
As we've already seen, the Dow's six tech components are under-represented thanks to a tendency toward low share prices. We could replace Cisco (NASDAQ:CSCO), the Dow's lowest-weighted component, with salesforce.com (NYSE: CRM) to get some cloud-computing representation and enhance tech's stature on the index. How might that work?


with Cisco

with salesforce.com

Dow component weight



Dow sector (retail) weight



Component weight on S&P 500



Market cap vs. replacement



Sources: Finviz, Yahoo! Finance, SlickCharts.

The cloud is certainly an important new subset of the tech sector, and adding Salesforce would help boost tech's value on the Dow to levels more appropriate to its actual economic importance. However, not only is Salesforce a fraction Cisco's size, its profitability is a mirage next to Cisco's (Salesforce has reported a net loss for the trailing 12 months). In addition, its free cash flow, while positive, is still a tiny fraction of Cisco's -- at current levels it would take Salesforce more than 15 years to generate as much free cash flow as Cisco earned over the past four quarters. It might help balance the Dow, but Salesforce wouldn't be a better representative for the tech sector than Cisco.

Boosting biotech
Health-care stocks don't get too much love on the Dow, even though the sector is one of America's most valuable -- financial, industrial, energy, and basic materials are all more heavily represented on the index despite accounting for lesser shares of the American economic pie. Part of that is due to Pfizer's (NYSE:PFE) low share price. The biggest of Big Pharma is third from the bottom on the Dow's weighting ranks, which means it exerts less influence than a number of companies a fraction its size. There are plenty of big pharmaceutical companies out there, but only a few are still based in the United States. Swapping Pfizer with biotech superstar Gilead Sciences (NASDAQ:GILD) might do the trick:


with Pfizer

with Gilead

Dow component weight



Dow sector (retail) weight



Component weight on S&P 500



Market cap vs. replacement



Sources: Finviz, Yahoo! Finance, SlickCharts.

The Gilead-for-Pfizer swap comes the closest of our three options to making sense from a market-cap standpoint. In fact, Gilead is the largest health-care component on the S&P 500 that is not also part of the Dow. However, this replacement would have made far less sense even a year ago, as Gilead's market cap and share price have both swelled 50% in 52 weeks on the back of monster sales of its new hepatitis C treatment Sovaldi. Pfizer, in contrast, has held up its share price with buybacks even as its market cap has declined by roughly 6%. The fortunes of Big Pharma can change rather quickly as drug patents expire, so while Gilead might eventually top Pfizer if the latter can't develop new blockbusters soon, it's not likely to hold the lead for the long term.

The Dow has retained its relevance with timely member replacements and clever choices over the past three decades. However, accurately tracking the market's moves may become impossible in time if America's largest and most notable publicly traded companies continue to trade at share prices that don't reflect their relative importance to the Dow. For a long time, the Dow was less important than many other indices. If its weighting system falls too far behind reality, it could become an afterthought again.

Top dividend stocks for the next decade
The smartest investors know that dividend stocks simply crush their non-dividend paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here now.

Alex Planes has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems, Costco Wholesale, Gilead Sciences, and Salesforce.com. The Motley Fool owns shares of Costco Wholesale and Gilead Sciences. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.

Compare Brokers