For more than 122 years, the Dow Jones Industrial Average has been viewed as America’s leading stock market index. Retail investors sitting in front of their computers to seasoned Wall Street veterans rely on the Dow to provide a glimpse of the health of the U.S. economy and the strength of its stock market.
The Dow is not a modern index. It is old and simple, created more than a century ago by Charles Dow, who co-founded Dow Jones and was the first editor of The Wall Street Journal. For many, this index is synonymous with the American stock market. Today, when someone says, “How did the market do today?” they’re probably asking about the Dow Jones Industrial Average.
But the Dow is hardly a reflection of the stock market as a whole.
It was useful to follow Charles Dow’s index before we had computers to calculate market movements, but no one would build a stock market index that way anymore. Professionals in the asset management industry don’t use the Dow as a benchmark because they understand its weaknesses. There are many other indexes out there. The S&P 500, for example, does a good job of measuring large-capitalization stocks, and it is often used by market pros to refer to the market generally.
But for all of its nostalgia and the more than 50 component changes the index has undergone since its inception on May 26, 1896, the Dow still has a pretty glaring flaw: it’s price-weighted, not market-cap-weighted. This means it judges stocks based on their share price rather than market capitalization.
Only 30 stocks are included in the index, which uses a measuring system so simple that it seems arbitrary: Stocks are weighted by price. That means that the highest-priced share of a stock — which happens to be Boeing at the moment — has the greatest sway in the index.
Consider the implications of using that kind of index. Imagine that you are a car collector creating a car index based on all of the cars you’ve bought over the years.
Let’s say your garage (or more likely, airplane hangar) has one Rolls Royce and 999 brand new Toyota Camrys–an unlikely scenario, granted, but we’ll pretend you’re an eccentric car buyer. In a price-weighted index, the Rolls will have the biggest overall impact because it’s the most expensive item in the bunch, even though you spent far more money on all those Toyotas. The rise and fall of the Rolls is the powerhouse that controls your price-weighted car index, even if you never buy another Rolls Royce again in your life.
Last year, industrial conglomerate General Electric, which had been a fixture in the Dow for the past 110-plus years, was removed from the index by the S&P Dow Jones Indices committee that meets a few times each year and is responsible for changing components in the Dow from time to time.
What’s notable about this move is that General Electric still maintained a market cap of around $115 billion when it was given the boot by the committee. This meant it was larger than six current Dow components based on market cap, and placed around No. 65 overall in market cap for publicly traded companies in the United States. It wasn’t exactly an irrelevant company.
However, General Electric’s share price had fallen due to weakening sales in a number of key operating segments. After sinking by more than 60% in a two-year span, GE was trading at $13 per share. Based on the Dow divisor published by The Wall Street Journal, General Electric was only responsible for about 90 of the Dow’s 25,300-plus points. This made it expendable in the eyes of the S&P Dow Jones Indices committee.
Because of the way the Dow Jones Industrial Average is calculated — by share price instead of market cap — the eight largest companies in the index aren’t even in its top three in terms of importance. This means that tech giants Apple and Microsoft, which each has a market capitalization of around $700 billion as of this writing and have significant weighting in the broader-based S&P 500, aren’t the leading movers of the Dow.
Apple is the biggest company in the entire stock market, but because of its share price it’s half as influential in the Dow as its fellow index member Boeing, which has a market capitalization of only about $167 billion.
Company size, not share price, is critical in the S.&P. 500. Stocks with a bigger market cap have a proportionately bigger impact on this index. This method of measuring a stock’s relative importance makes it a “market-weighted index.” This is one reason professionals use it much more widely than the Dow.
The S&P tells you much more about how the market is really doing. Modern indexes that track stock markets are generally market weighted.
The benchmark you should be looking at really depends on your portfolio. Not many people are invested in only an S&P 500 index fund, so using the S&P 500 as your benchmark may not be the best idea. A blended benchmark made up of several indices is probably the best approach.
At Azzad, we have worked with S&P Dow Jones to create custom benchmarks for all of our model portfolios, and have also created blended benchmarks for our allocation strategies. That’s the way to go. Otherwise, when you look at the return for “the market” on a given day, you’re going to be tricked into thinking that this is how your portfolio performed. That’s almost never the case.
If your portfolio is diversified enough to capture the entire market, it probably isn’t turning in a performance as horrific as the daily news reports suggest. The problem may just be that everybody is talking about the Dow — they’re not really talking about the stock market.
So, don’t pay as much attention to the Dow as a measure of economic and stock market health. It’s just not that important.
