The Dow Jones (^DJI 0.67%) 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 (IBM 0.18%) commands more than 11% of the Dow, while Bank of America (BAC 2.06%) makes up 0.6%, even though IBM is only about twice the size of B of A. Some have pointed out that if Apple (AAPL 0.51%) became a Dow component, its high share price would utterly dominate the entire index, even though other companies such as ExxonMobil (XOM 0.57%) 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.
