August 10, 2014

The Dow Jones Industrial Average is a Weird Index

Financial reporting constantly baffles me. Talking heads on CNBC and market updates on the radio are always spouting off about what the Dow or the NASDAQ did on a given day. In reality the S&P 500 is really the only major index that actually gives an accurate overall benchmark of U.S. stock performance.

The NASDAQ is fairly useful if you're interested in how tech stocks have performed on a given day. While many non-tech names have crept into the NASDAQ over time, it's still very heavily-weighted toward to tech. Those who believe we're in the midst of Tech Bubble 2.0 may be watch it particularly closely. Like the S&P 500, the NASDAQ is market cap weighted.

Some of the big name stocks in the Dow Jones Industrial Average: Visa, IBM, 3M, Exxon, and NikeThe Dow Jones Industrial Average, however, is price-weighted (as is the Nikkei 225). Yes, the DJIA is based on the share price of each of its 30 constituents rather than market caps. I'm sure this seemed like a great idea back in the 1800's, but for the life of me I can't figure out why anybody cares about this index today. Yes, the 30 "major" American companies in the index are probably a decent approximation of blue chip stock performance. But Visa, roughly the 35th largest U.S. public company, is the largest component of the Dow at 8.2%. Meanwhile, Exxon, the 2nd largest public company by market cap, accounts for less than half as much of the DJIA (3.85%).

Visa's stock price at over $210 is twice that of Exxon at just under $100, but so what? Exxon is an over $425 billion company while Visa is around $132 billion. The Dow does factor in stock splits using the Dow Divisor, but overall the S&P 500 just seems so much more meaningful. While S&P Dow Jones states, "This application of grade-school arithmetic, while creative, is hardly useful more than a century later," I'll continue to tune out financial reporters as they spout off daily DJIA figures.

I am not sure why anyone would be particularly interested in investing in an ETF using this price-weighted methodology. Nevertheless, the SPDR Dow Jones Industrial Average ETF (DIA) has managed to amass nearly $11 billion in assets of the years. Thankfully this is tiny compared to more sensibly cap-weighted ETFs like QQQ and SPY (nearly $44 billion and $158 billion in assets respectively).

Update: CBS Money Watch just posted another comparison between the DOW and S&P 500 here.

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