The Dow Jones Industrials (DJINDICES:^DJI) has put together an impressive performance over the past year, rising more than 22% when you include the impact of dividends. But if you took out one of the Dow's more peculiar attributes, using its components to invest in a simpler fashion would have given you even better returns. By using an equal-weight strategy rather than the Dow's price-weighted methodology, you could have earned a couple extra percentage points of return -- thanks largely to Bank of America (NYSE:BAC).
How the Dow works
The way the Dow is calculated is different from just about every other major market benchmark. Rather than looking at market capitalization, the Dow simply adds up all the share prices of the 30 stocks in the average and then divides by the current Dow divisor. The resulting figure gives you the Dow's value for the day.
The practical impact of this method is to give the stocks with the highest share prices undue influence over the average. As long as the stocks perform roughly in line with each other, the weighting methodology doesn't produce dramatic disparities.
But sometimes, the impact is substantial. With Bank of America, the stock has soared more than 70% over the past year. With its $13 share price, the company has an influence of only two-thirds of a percentage point. In an equal-weight Dow, though, it would have about five times that influence -- and add a couple of percentage points by itself to the average's overall performance.
At the other end of the spectrum is IBM (NYSE:IBM), which is by far the most influential stock in the Dow. Its 5% return over the past year isn't all that bad, but because IBM has more than 10% weighting in the average, its underperformance cost the overall Dow more than a percentage point of returns compared to an equal-weight Dow.
Offsetting the impact
Still, sometimes, good and bad performances cancel each other out. The smallest stock in the Dow, Alcoa (NYSE:AA), was also its worst performer, losing 5% since last June. But since its shares fetch only about $8, that loss barely affected the Dow at all. In an equal-weight Dow, however, it would have just as big an influence as any other stock.
In the end, when you look at the entire universe of stocks, an equal-weight Dow would have produced a one-year return of almost 25%. That's a nice boost over the actual Dow's results, but at just a few percentage points, it's nothing to panic over. If anything, the small difference proves that the Dow's sometimes-controversial methodology doesn't have as dramatic an impact as many people believe.
Fool contributor Dan Caplinger owns warrants on Bank of America. You can follow him on Twitter: @DanCaplinger. The Motley Fool recommends Bank of America and owns shares of Bank of America and IBM. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.