Is the Dow still relevant?

When Charles Dow created the Dow Jones Industrial Average index in the late 19th century, he could hardly have guessed at its longevity or its influence. 

Over 120 years later, the Dow, as it is often called, is one of the most-cited indices in the world and is often considered a barometer of the US economy. When the Dow first broke 10,000, New York City mayor Rudolph Giuliani and the New York Stock Exchange celebrated with “Dow 10,000” baseball caps.1 

However, the unique way in which the index is comprised and formulated has led some commentators to question its relevance and even consider it to be meaningless.

How it all began

Charles Dow, the co-founder of Dow, Jones & Co. and the Wall Street Journal, created the DJIA in 1896. It was designed to track what he considered to be the 12 most important American industries. 

Companies in the original index included American Cotton Oil, Chicago Gas, U.S. Leather, National Lead and Tennessee Coal Iron.

General Electric is the only founding company that still features on the Dow, though it has been removed and reinstated twice.

Although the index was increased to track 30 companies in 1928, it hasn’t grown in number since then.

How the Dow companies are chosen

A small group of Wall Street Journal editors selects the companies that make up the index, the goal being to reflect the market in just 30 stocks.4  

The Dow is different from those indices that are weighted based on market capitalization. Instead, the Dow is based on share prices, which are divided by an adjustable divisor. This helps balance the index whenever a company splits its shares.  

The Dow is often criticized for being slow to include certain companies while keeping others for too long. One key example is Apple. The tech company’s share value had risen so high that it would have distorted the index. Apple only joined the Dow in 2015, after it split its stock.

Why it may not be the best indicator of your portfolio’s performance

There are a number of reasons why you should be cautious when following the Dow’s performance. 

High-priced stocks have more influence than lower-priced companies, which can lead to some strange anomalies. For example, a company with a market cap of $10bn and a share price of $50 has twice the impact on the index’s performance than a company with double that market cap but a share price of only $25.5

In extreme cases, as much as 80% of the Dow’s fluctuations can be caused by as little as two companies.5 This explains why it may not be an accurate indicator for investors with diversified portfolios. 

Points to remember about the Dow

In tracking only 30 companies, the Dow doesn’t accurately reflect either the whole stock exchange or a diversified portfolio. 

A single company’s performance can cause the Dow to drop considerably, as was recently seen after Home Depot’s disappointing sales announcement.7 The Dow can also move in the opposite direction to the market cap-based indices. 

If you’re looking for an indicator of the stock market or the economy as a whole, the S&P 500 and the S&P/TSX (for the Canadian market), may be better choices. 

 

References

Corrie Driebusch and Aaron Kuriloff, “It’s Almost Dow 20000: Where’s the Party? Where Are the Hats?” The Wall Street Journal, December 14, 2016. https://www.wsj.com/articles/its-almost-dow-20000-wheres-the-party-where-are-the-hats-1481739537 (Accessed May 22, 2018).

2 Georges Ugeux, “Is The Dow Jones Industrial Average Index Misleading Or Meaningless Or Both?” Huffington Post, February 17, 2017. https://www.huffingtonpost.com/entry/is-the-dow-jones-index-misleading_us_58a64b5ae4b0fa149f9ac40d (Accessed May 11, 2018).

3 Steve Schaefer, “The First 12 Dow Components: Where Are They Now?” Forbes, July 15, 2011. https://www.forbes.com/sites/steveschaefer/2011/07/15/the-first-12-dow-components-where-are-they-now/#3a708951b032 (Accessed May 14, 2018).

4 John A. Prestbo, “Secrets of the Dow Jones Industrials.” Wall Street Journal, May 8, 2016. https://www.wsj.com/articles/secrets-of-the-dow-jones-industrials-1462759211 (Accessed May 14, 2018).

5 John Jacobs, “Don't confuse Dow Jones records for overall economic prosperity.” The Hill, August 3, 2017. http://thehill.com/blogs/pundits-blog/finance/345136-dont-confuse-dow-jones-records-for-overall-economic-prosperity (Accessed May 11, 2018).

6 Adam Davidson, “Why Do We Still Care About the Dow?” New York Time, February 8, 2012. https://www.nytimes.com/2012/02/12/magazine/dow-jones-problems.html (Accessed May 11, 2018).