Why the Dow is Dumb

By Kevin Chambers

One of the big news items this week was the announcement that General Electric, one of America’s most famous companies, was being taken out of the Dow Jones Industrial Average. Although this made a lot of headlines, it doesn't really matter. And here is why.

The Dow Jones is one

of the most reported stock market indexes. Indexes are groups of securities that attempt to mirror a market. The theory is that by seeing the performance of the index, you can understand the movement of the market as a whole. For the US stock market, this means getting together a group of companies to be a realistic measure of the whole market. However, the Dow Jones is not a very good indicator for the whole market. It only includes 30 companies, and its method of calculating their average leaves many of the largest, most successful companies out of their index.

The Dow Jones is a price-weighted index. All they do is add up the prices and divide by a divisor based on the value of the stocks in the index. The divisor started at 12, because there were originally 12 companies in the Dow, and is now at 0.132129493. Because some of the large companies have insanely high stock prices, their prices would overwhelm the other stocks in the index. For example, if Amazon (AMZN $1,701.45) or Berkshire Hathaway (BRK-A $284,920) were in the index, any change in the price in their stocks would shift the index. The most expensive stock in the Dow is currently Boeing (BA) at $334.65. On the other side, GE was taken out of the Index because their price fell below $14 and is now considered too low to be a part of the index.*

Because the Dow uses a price index, any stock that has a high price will never be in the index. Up until about 20 years ago, most companies would do a stock split, double the number of shares. Say Disney was worth $100. Every shareholder would now have two shares of Disney worth $50. No one loses or makes money, but the stock price is lower, and thus more assessable for investors to buy. However, today, the majority of investors use mutual funds, who buy large quantities of stock, and don’t care about what the price is. Thus, there is less incentive for companies to artificially lower their stock price.

Other indexes use a different system to build and value their indexes that make them more representative and a better reflection of the market. The other leading index is the S&P 500. They use market capitalization or the value of a company’s outstanding shares. In other words, the number of shares multiplied by the price of those shares.  The top 500 companies, by market cap, are included in the index. This is an important distinction.

Let's look at Berkshire Hathaway again. It has a super high stock price of $284,920 and a market cap of $469 billion. Apple has a stock price of only $185.5 (APPL), but a market cap of $911 billion. Stock price is not a very accurate indicator of the value or impact a company has on the overall market. Market cap better reflects the influence a single company can have on the overall market. The S&P also only uses shares that are available for public trading. It excludes the shares in a company that are held by the company itself, company offices, controlling investors, or the government. Thus, it represents the actual shares that could trade on any specific day, letting it be even more representative. The S&P 500 is also much more diversified as it includes 500 companies instead of the 30 companies represented in the Dow Jones.

Most financial professionals don’t use the Dow Jones for serious economic research. It is a popular data point on which journalists to base headlines. So although GE leaving the Dow is an interesting story about an American institution needing to retool for the 20^th century, in terms of financial impact on portfolios, it was mostly ignored.

*Stock Prices accurate as of the original posting of this blog entry