Came across this this evening and immediately thought of this thread. ( H/t Cullen Roche at Pragmatic Capitalist )
http://pragcap.com/can-we-all-agree-to-stop-citing-the-dow-jones-industrial-average
The Dow Jones Industrial Average is a terrible index of “corporate America”. I don’t know why anyone still cites it. I know, it’s a relic of an era long past. But can we all just agree to let it die? Can we all just agree to stop citing it? We have much broader indices that are much better and more accurate representations of the health of corporate America. So why do we continue to cite this index of 30 random companies when we have indices that span such a broad swath of corporate America?
The reason I bring this up is because I was reading this piece on Business Insider citing Warren Buffett and how you shouldn’t assume that the stock market will grow just because the economy grows. And the piece cites a period from 1964-1981 when the Dow didn’t budge, but the economy expanded by 3X. It’s true:
But the same thing isn’t true for the S&P 500 which expanded by 47% during this period:
Yes, I agree with the broader point – the stock market is not the economy. The stock market tries to front-run the economy. So there’s a difference in the cyclicality at work there and we should never assume that future economic growth means future stock market growth. But the next time someone cites the Dow please sit them down and tell them that the Dow Jones Industrial Average is an index that our grandfathers used because there was nothing better. And then let them know that there are much better indices that represent the state of corporate America. They’ll thank you when they realize how deceptive a 30 company slice of corporate American can make things appear….
And from Kid Dynamite in the comments:
http://kiddynamitesworld.com/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. ( R squared of 91.4 )
esp. it's an idiots index, that says it all.