Dow Jones Industrial Average Is a Horribly Constructed Index

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.


DIA vs SPX 5 year Chart


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*…


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.

Kid Dynamite is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to If you click on my links and buy anything, even something other than the product advertised, I earn a small commission, yet you don't pay any extra. Thank you for your support.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

blog comments powered by Disqus
Kiddynamitesworld Blog