37. The Dirty Little Secret of the Dow Jones Industrial Index

It's the second oldest index around: since its inception in 1896 it saw countless market cycles, from the great depression to the booms and busts cycles of recent years. It's often the first (or only) quoted index in news reports about the market. And it, supposedly, tracks the largest companies in the US - the bellwethers of the economy.

What can be wrong with that?

The dirty little secret is that the Dow Jones Industrial Average (DJIA) is a pretty crappy index, and a lousy way to measure market performance.

For a start, it tracks only 30 companies. Indeed, all are pretty big, from ExxonMobile to Bank of America, from Disney to Microsoft. But these are not even the largest companies in the US. In fact, the DJIA does not include Apple, which competes with ExxonMobile for the top spot. With so few companies in the index, can you imagine what including Apple would have done to the performance of the index in the last year?

Well, it's not difficult to figure this out, because the DJIA is a price-weighted index. In a nutshell, the value of the index is the sum of the prices of all the stocks in the index, multiplied by a factor, currently about 7.5. (The factor is adjusted when the companies are added or removed from the index.) If Apple were to be included in the index, the company meteoric rise from $200 to around $400 a share in recent years would have added 1500 points to the DJIA! Similarly, AIG stock's 90% collapse in 2008 contributed to a roughly 3,000 point drop in the index, only because the stock price was in the hundreds. Today, after a reverse-split, the stock trades around $22. A similar drop would contribute only to a 150 point drop in the index.

Even worse, the companies in the index have very different share prices. While ExxonMobile (XOM) is traded at $74 a share, Bank of America (BOFA) is traded around $6. This means that a 20% decline in BOFA accompanied by 2% appreciation of XOM will result in a modest gain to the index. If BOFA went bust tomorrow morning and its stock price went to 0, the direct impact on the DJIA would be a drop of 45 points.

Does it make sense to you? It doesn't make any sense to me. But yet, millions are watching this index and its movements religiously. Professionals, however, are likelier to use the S&P 500 as a benchmark for the market and the economy: it contains the largest 500 companies, and is cap-weighted, i.e., the contribution of different companies are weighted according to their total market value. Even fancy modifications of this index, like the equal-weight S&P I mentioned last week, are better than the ridiculous DJIA.

One reason people still use this aging monster is that, against all odds, it's highly correlated with the S&P 500 index. Check this chart, for example:

In fact, the picture from this graph shows that the DJIA is only 10% off the S&P over the last 5 years. Not bad for an index with such a questionable composition. Perhaps this shows how interrelated our economy has become, and how we all go up or go down together. Or perhaps I'm missing something, a magical touch that makes the DJIA the venerable index it is today. What do you think?