Recently, there has been quite a bit of hype over the DJIA (Dow Jones Industrial Average) hitting 20,000 and setting a new record. Market professionals don’t take the Dow Jones very seriously, preferring to look at other indices such as the S&P 500. Let me summarize why the Dow Jones doesn’t deserve your time and attention.
The first thing to know about the Dow is the fact that it was designed back in May 26, 1896 when computers did not exist. To work around this dearth of computing power, the founder, Charles Dow, simply added the prices of 30 companies he thought best reflected the US economy and divided by the Dow Divisor.
Keep in mind, history is quite literally the only thing the DJIA has going for itself. It is the longest running market index we have for the US.
Small Sample Size
There are only 30 (admittedly very big) stocks in the DJIA, amounting to a paltry 29% of total US market cap. Compare this number with S&P 500, which has 500 companies and covers around 80% of total US market cap.
There is no set criteria used to consider a company’s eligibility to be part of the Dow. It (kind of) makes sense back in 1896 when you had to use your gut to determine which companies to include (and it might make even more sense if the number of publicly traded companies with large market cap was relatively low).
Consider the index today. Microsoft and Apple is in but not Alphabet or Amazon?
Again, compare this logic to S&P 500 which simply takes the 500 largest company based on market capitalization (and so has all four).
First, this is actually a misnomer. The Dow Divisor is a number less than 1 (at the time of writing it is
0.14602128057775). So really, it’s more of a “Dow Multiplier.”
On a more serious note, the Dow Divisor isn’t a magic number that people are aware of. Instead, it is a number that changes periodically to keep the historical continuity of the index given the numerous stock splits, spin-offs and changes among the Dow companies.
You might think the grievances I have with the Dow are minor so far, but this next one will change your mind.
Here’s a quick finance interview question for you: What is a better indicator for a company’s worth: the stock price or its market capitalization?
You see, the Dow places the importance of a company on its stock price, even though stock price alone is not an indication of the company’s quality or profitability.
Let’s say you start a company and issue 10 stocks priced at $10, while I open a company and issue 100 stocks issued at $1. Our companies would be worth the same at $100, but the DJIA would be swayed more by your company because your stock price is higher. To drive this point home, if your company gained 5% (and rose to $10.50) in stock price and mine lost 5% (and fell to $0.95), the index would go up (despite the fact the overall market cap would be unchanged).
There are obviously a lot we could do to change and fix this index, but remember that the only thing the Dow has going for itself is that it has a long history. So officially, their stance is the following:
With little to gain, except maybe a reduction of criticism, we have no reason to re-weight The Dow® to market capitalization. And there would be a lot to lose: all the history that is in price-weighted terms.
So now what?
Follow the S&P 500.
However, keep in mind: while the S&P 500 is a much better indicator of our economy than the Dow Jones Industrial Average, it does not perfectly reflect our economy. While the indices correlate with the economy, no market index will perfectly capture all the numbers that are necessary to fully understand the economy. Apart from the stock market there are a host of other numbers that will paint a clearer picture: GDP, housing, unemployment, etc.