The Trouble with the Dow

. . . the Dow Jones Industrial Average (DJIA), that is.  While it gets all the headlines, it’s a very flawed index of stocks, as it’s a price-weighted index.  That means component companies have weights in the index proportional to their prices

Here is a look at the current DJIA constituents, sorted by their weights as based on yesterday’s closing prices.

Naturally, what should jump out is the disparity that arises just because IBM chose to not split its stock, while Caterpillar had a two-for-one stock split in 2005.  Had CAT chose to not split its stock, its weight in the index would be greater than IBM’s

There is a very solid reason for why the index is constructed in this fashion, and that’s because in 1896, when it was created, it was a whole lot easier than any other scheme.  Why it continues to this day must be just for the ease of comparison.

As I type this, my spreadsheet has the DJIA down by 1.38% based on this weighting scheme.  The top six stocks in the list at left–why the top six? no good reason; just that the seventh one is positive–are responsible for 65% of that decline, or 0.90% of the 1.38%.

Expressed differently, the chart below shows the percentage of the total comprised by each price quintile of the constituents (e.g. Quintile 1 represents the six highest-priced stocks; Quintile 2, the next six; and so forth).  By definition, each successive quintile represents less and less.

This caused me to do some thinking–always a dangerous prospect, as there are a number of ways to construct an index.  So, I built a spreadsheet that takes the 30 DJIA constituents and looks at them under three different regimes.  The chart’s a bit messy but easy to explain. 

  1. The current constituents are listed, in their current order, in the far left column.  They’re ranked, from 1 – 30, in order of their prices; thus, IBM has the highest share price; Bank of America, the lowest.  Utter nonsense, but understandable, and, now, quaint.
  2. Next, they are ranked according to market capitalization, in the common “cap weighting” methodology.  This is a bad way to invest, as one ends up with most in the over-valued companies; least in the undervalued.
  3. Finally, the third column shows the rankings if they were ranked in order of net income.  That’s hardly a perfect measure, given that some companies are cyclical. 

For example, Caterpillar, which is highlighted, has the second-highest representation in the current Dow 30.  It drops to 23rd when ranked by market capitalization; 26 when ranked by income.

There’s only about one observation to be made from the bird’s nest below, and that is that the Dow 30 is, at best, a very, very general indicator about the direction of stocks, and even at that, it’s movements are highly subject to the movements of a handful of the highest-priced companies in the index. 

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