The Dow Jones Industrial Average is perhaps the most widely-followed index in the world, regularly displayed as a gauge of both short-term and long-term stock market performance.
Most investors are aware of the quirks behind the Dow 30 methodology, and the limitations on its usefulness as a result. Below are three charts that illustrate the shortcomings of the Dow Jones Industrial Average as a true measure of the U.S. stock market.
Limited Representation
The Dow consists of 30 “blue chip” stocks. This portfolio obviously represents a relatively small portion of the total U.S. stock market. The following chart shows the 3,000 or so stocks that make up the broader Russell 3000 index — scaled by market capitalization — with the Dow components highlighted in green.
The Dow obviously misses out on a huge section of the total U.S. stock market. It also overlooks some of the largest companies for much smaller components; Travelers (TRV) and DuPont (DD) in particular are relatively small companies; their combined market cap is about 20 percent of Google’s.
Arbitrary Weightings
The Dow is a price-weighted index, which means that it simulates the experience of holding a single share of each company. As a result, companies with higher per share prices exert greater influence on the movement of the index. Because per share price is somewhat arbitrary — Apple underwent a 7-for-1 split earlier this year — so too are the weights of the stocks within the index.
The following chart shows the weight of the 30 Dow stocks as a multiple of their weight in the Russell 3000:
Another way to visualize the arbitrary nature of a price-weighted methodology is to examine how the index would look if certain stocks were to be added. The following chart shows the weight various stocks would receive in the Dow if they were to replace General Electric (GE), which has the lowest weighting currently:
The Dow has a lengthy history and a recognized brand, so it will likely continue to be the primary stock market indicator. While it may be a useful gauge of a certain segment of the stock market, an understanding of the methodology and limitations should lead investors to discount its importance.
This article, Why the Dow 30 Is a Terrible Benchmark, first appeared on Dividend Reference.