Dow Jones Industrial Average Is a Horribly Constructed Index

• Posted by kid dynamite
• on February 9th, 2012

I hate the Dow.  There’s a reason:  it’s an idiot’s index.   I don’t mean to insult anyone, it’s just that you have to understand how the Dow index is actually constructed – and once you understand it, you should agree “wow, that’s asinine.”

The New York Times’ Adam Davidson gets into it a little bit in his piece “Why do we still care about the Dow?“    But it’s really simple:  the Dow is a price weighted index.  That means that the index “holds” the same number of shares of each stock, and that the index components with higher prices have higher weights.  Since stock price is essentially a random number – in the sense that companies can change their stock price without changing the value of their company by splitting or reverse-splitting their shares – this is an utterly absurd way to create an index.

Who would ever create a portfolio like that?   When you trade/invest/whatever, you don’t buy the same number of shares of each stock.  You might weight your portfolio by dollar value, by volatility risk, by some sort of risk-weighted metric, by market cap, by earnings multiples, by geographical location, by sector  – anything but equal share counts.

The Dow is such a ludicrous index that when one of the Dow components splits, indexers must sell shares of that component and buy shares of all of the other components with the proceeds.   Moronic.

Why, then, is The Dow the favorite of the retail market?  Well, tradition first and foremost – that’s the way it was back in the day, and the status quo is a driving force.  Secondly, stocks are correlated, especially the type of large cap stocks that make up the Dow and account for much of the weight of the S&P 500.   Even with the insane price weighting methodology, the Dow’s performance has been highly correlated to the S&P 500.

 

 

In some sense, it’s dumb luck – the Dow has succeeded IN SPITE of its construction, not because of it.  Maybe there’s a lesson here after all:  in a market like this, it doesn’t really matter how you weight your portfolio*…

-KD

disclosure: no positions in $DIA

* it should be clear from my use of the words “moronic,”  “asinine,” and “idiotic” that I am not suggesting that anyone weight their portfolio like the Dow is weighted.

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