Why the Dow Jones Industrial Average Is Pointless

For a couple of weeks now, we’ve all heard the talk of “Dow 20,000.” And while the Dow Jones Industrial Average, as the index is officially called, hasn’t quite reached 20,000, the very fact that anyone in the market even cares is striking. Because the Dow Jones itself is a measure of very low value, oddly set up and almost archaic in a computer age.

Why the Dow Jones Industrial Average Is Pointless

There’s a lot of commentary that seems to imply that the Dow Jones Industrial Average is representative of the broad market. It’s a strange claim, and it’s hardly the case.

The Dow consists of just 30 stocks. And the DJIA is price-weighted, meaning that a stock’s actual price is more important than the market valuation of the underlying company. While the index attempts to represent the U.S. economy as a whole, it comes nowhere close to representing U.S. stock markets as a whole.

So whether the Dow hits 20,000 or not should be of little interest to investors. It’s just a number, and the mechanics of the Dow Jones Industrial Average mean that number isn’t very meaningful.

It’s Price-Weighted (Really)

The smallest company in the Dow Jones Industrial Average by market cap is insurance firm Travelers Companies Inc (NYSE:TRV), worth roughly $33 billion. The largest market cap in the index is Apple Inc. (NASDAQ:AAPL), the most valuable company in the world, worth roughly $630 billion. In other words, Apple is worth ~19x as much as Travelers, at least in terms of its equity value.

But the Dow Jones is not market cap-weighted; it’s price-weighted. That literally means the index moves based on the share price of the respective components. AAPL closed trading Monday at $118.99. TRV closed at $117.32. What that means for the DJIA is that a 5% move in TRV impacts the index almost as much (in fact, 98.6% as much) as a 5% move in AAPL. That occurs even though Apple is worth almost 20 times as much as Travelers.

Because the DJIA is price-weighted, the most influential company in moving the Dow Jones Industrial Average isn’t Apple or Microsoft Corporation (NASDAQ:MSFT) or Exxon Mobil Corporation (NYSE:XOM). It’s Goldman Sachs, which closed Monday at $242.89, the highest share price in the Dow. But Goldman, by market cap, actually is the seventh-smallest of the 30 Dow Jones Industrial Average issues, with a market cap just under $100 billion.

In contrast, JPMorgan Chase & Co. (NYSE:JPM) is worth more than three times as much as Goldman, yet contributes barely one-third as much to index performance as its smaller rival.

The impact of price-weighting isn’t simply mathematical, or limited to the performance of the index. It affects the index itself. The only reason AAPL even is included is because it undertook a 7-for-1 stock split in 2014 — around the same time as Visa’s (NYSE:V) 4-for-1 split. That left Visa’s share price too low, as the Dow’s owner explained a year later when Apple was included, and allowed AAPL to enter with a more “normal” stock price.

The very fact that the Dow wouldn’t have included AAPL — again, the world’s most valuable company — because of its share price shows just how silly the index is.

And Only 30 Stocks

Apple is in the index now, but there are many notable omissions. Alphabet Inc (NASDAQ:GOOG, NASDAQ:GOOGL), Amazon.com, Inc. (NASDAQ:AMZN), and Facebook Inc (NASDAQ:FB) all are excluded. Amazon, in fact, now suffers from the same problem that AAPL did three years ago, as its share price nears $800. (A champagne problem, to be sure.) But, like Apple in 2013-14, it seems crazy that Amazon.com doesn’t even count in the Dow at all.

Indeed, the fact that the dominant retailer in the U.S. — a company that quite literally is reshaping the consumer landscape in this country — isn’t included shows the limitations of the Dow Jones Industrial Average. It is supposed to be a index that represents the U.S. economy, yet it doesn’t include what seems like the most innovative, disruptive company in that economy.

So why is the Dow Jones still used? Inertia is probably the most logical reason. The simplicity of the index and even its name lends itself to quick media soundbites. “The Dow closed down 80 points today” appears an easy way to describe the market’s action.

But easy isn’t accurate, particularly in this case.

The nature of the index lent itself well to market coverage decades ago. Changes in a 30-stock, price-weighted index could be calculated with pen, paper and a calculator (with the latter tool optional). But in the computer age, when second-by-second updates are available worldwide, for free, the insistence on following the Dow makes little sense.

The S&P 500 has the limitation of focusing almost solely on large-cap stocks, but it at least accounts for ~80% of total U.S. market value by most estimates. The Wilshire 5000 covers almost the entire U.S. market. The Russell 2000 gives a glimpse into the movement of small-cap stocks. And the Nasdaq-100 — which does include AMZN, FB, and GOOG — is a useful shorthand for understanding the market’s sentiment toward tech.

There’s another thing those indices all have in common: they are weighted by market cap, not by price. In other words, they cover more stocks in a far more accurate manner.

So if you’re wondering whether the Dow will hit 20,000, save the time. There are many more useful indices out there.

As of this writing, Vince Martin did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media, https://investorplace.com/2017/01/dow-jones-industrial-average-pointless/.

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