“The Dow’s advantage is its iconic status. However, there are vastly better things to use for both investing and benchmarking.” - Simon Moore, Forbes
Today we want to talk about the Dow Jones Industrial Average, or as many affectionately call it, “the Dow”. The Dow is the oldest, most iconic market index in circulation, and despite being well over a century old it is still quoted on the nightly news, plastered on the home page of every financial media website and on the tip of most investors’ tongues when discussing how “the market” is performing.
It is also the most irrelevant measure of broad stock market performance in existence today.
First, a little history lesson. The Dow Jones Industrial Average was created in 1896 by Charles Dow, founder of the Wall Street Journal. Amidst the stock market boom of the 1890’s, Mr. Dow observed that a wave of mergers and acquisitions was taking place and that as companies scaled into large corporations their need to tap the equity markets for growth capital was increasing exponentially. Investors needed a better way to track the aggregate behavior of these companies’ prices, so Charles Dow, along with his business partner Edward Jones, created a number of market indices to address that need. This, essentially, was the first time there was a broadly disseminated measure of the overall performance of the broad market.
Among these early indexes was the Dow Jones Industrial Average. The Dow in its original form included only 12 companies, all of which represented major names in the heavy industrial sector (hence the name). The table below lists the original twelve companies included at the index’s inception.
The lineup of stocks comprising the Dow is still selected on a discretionary basis by the editors of the Wall Street Journal. The composition of the index has changed 51 times since its inception in 1896, including an increase in the total number of names to 20 in 1916 and then to 30 in 1928. The most recent revision came in March of this year when AT&T was replaced by Apple.
There is no set rule or methodology that dictates when a stock will be added or removed from the index. Rather, the selection committee attempts to maintain a mix of stocks that more or less represents the United States economy as a whole. The table below lists the 30 companies that currently make up the composite. Clearly the index is no longer dominated by companies in the “industrials” sector, but now includes broad exposure to other sectors such as consumer goods, banking and technology.
Perhaps the most interesting characteristic of the Dow is the way it is calculated. But before we get into that let’s look at the way most other market indexes are calculated – using a “capitalization weighted” methodology. In a cap-weighted index each stock’s representation is based on its total market capitalization, calculated by multiplying the total number of shares outstanding by the current price per share. A stock’s market cap is the current value of all its outstanding equity and is essentially a measure of its size. So if you think of the total stock market as an ocean, a stock’s market cap is the measure of how much of the water in that ocean it represents.
Weighting an index by market cap makes intuitive sense when you think about it. Larger companies represent more of the total market and thus should occupy more space in the index. As an example, consider General Electric with a market cap of $271 billion and Goldman Sachs with a market cap of $91 billion. General Electric is three times the size of Goldman Sachs, and thus represents three times the amount of water in the stock market ocean. A cap-weighted index would therefore assign three times the weighting to General Electric as it would to Goldman Sachs.*
The Dow, on the other hand, is what is called a “price-weighted” index. When the index was first launched Charles Dow would add up the prices of all 12 companies and then divide that sum by 12 to arrive at the index’s daily value.** An implication of this methodology is that stocks that trade at higher prices receive a higher weighting in the index than those that trade at lower prices - regardless of the total market capitalization of the company. Going back to our example, General Electric stock trades at a price of $27 per share while Goldman Sachs trades at a price of $211 per share. As a result, Goldman carries nearly eight times the weighting of General Electric in the Dow, despite being roughly one-third the size on a market cap basis! Another glaring example of this distortion is Apple stock which carries a weighting 4.9% in the Dow despite the fact that it would have a weighting of roughly 14% if the index was cap-weighted – a different of nearly 10%.
Since there is no direct relationship between a stock’s price and its relative size or relevance in the market, there is absolutely no fundamental reason why an index would weight its constituents by their individual shares prices. It makes the weighting schema completely arbitrary, and it’s the reason why, at least to our knowledge, the Dow is the only example out of hundreds of American stock market indexes where a price-weighting methodology is used.
In addition to its flawed calculation methodology, we also think that limiting an index to only 30 companies when the American economy has grown so tremendously over the past 100+ years makes little sense. These shortfalls are widely understood, and as a result no financial professional really gives the Dow any credence as a measure of broad market performance. Rather, its staying power as a hallmark in financial media and popular culture is rooted in its long track record and a history wrapped in tradition and nostalgia.
For these reasons we believe the Dow is the most irrelevant measure of broad stock market performance in existence today. We would encourage our clients, and any other serious investors, to more or less ignore the iconic index and find more appropriate benchmarks against which to measure their portfolio and asset class performance – a topic we plan to cover more comprehensively in a future Insight.
*There are other weighting methodologies such as equal-weighting that also make sense for varying reasons, but we won’t go into them here.
**The denominator in this calculation, called the Dow Divisor, has been adjusted over time to account for stock splits, spin offs and other corporate actions in order to maintain historical continuity of the index’s level.
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
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