Founded by Charles Dow in 1896, the Dow Jones Industrial Average follows the price performance of 30 large, publically traded American companies. Since its creation, the Dow has served as one of the world’s most acknowledged financial indices, and is commonly displayed on the front page of newspapers and financial websites worldwide.
From industrials to technology and financials to retailers, the Dow is designed to represent a complete, well-balanced picture of how American large-cap stocks perform on a given day. The current list of Dow holdings can be found here, courtesy of CNN.
While the Dow’s longevity is indicative of its historical effectiveness and importance, many of its methods are antiquated in today’s day and age. The following information is intended to explain how the Dow Jones Industrial Average works and why it may need an overhaul.
The Dow’s System of Weights
The amount of weight that one company carries in the Dow is determined by the price of its stock. While the formula can get convoluted with stock splits and dividend payments, individual stock prices remain the primary determinant of index weight. For instance, a $100 stock carries 10 times more value than a $10 stock, regardless of value or relative importance of the two companies.
Given the weights of these five Dow stocks, it’s easy to see why this system has drawn heavy criticism over the years.
Although IBM (IBM) is worth 25 percent less than Microsoft (MSFT), it carries six times more weight. As a result, IBM carries enough weight to singlehandedly move the index with a significant price movement, while Microsoft, a more valuable and equally relevant company, is negligible.
Meanwhile, Alcoa (AA) and Bank of America (BAC) both hold weights of around 0.5 percent, although Bank of America is worth approximately 17 times more.
This price-weighting system also means that $1 changes in Bank of America and a $1 change in IBM moves the Dow by the same amount. However, in reality, a $1 price increase in Bank of America creates $10 billion in market value, which is 10 times more than a $1 change in IBM. Perhaps this illogicality means that it’s time for the Dow to follow in the footsteps of the S&P 500 and Nasdaq, which use market capitalizations to determine stock weights.
The Stocks in the Dow
One of the Dow’s strengths is its broad range of stock components. The Dow has just about everything: healthcare providers, automakers, financials, retailers, tech companies, utilities, and so on.
What the Dow lacks, however, is four of America’s most influential and valuable companies – Apple (AAPL), Google (GOOG), Amazon (AMZN) and Berkshire Hathaway (BRK.A).
Although all four companies are worthy of becoming Dow components, the price-weighting model sparks complications. Apple would account for almost 20 percent of the Dow, Google 40 percent, and Amazon 13 percent. Berkshire Hathaway’s $169,000 stock price would make up almost the entire index.
This is an obvious shortcoming because these companies are too important not to include in the world’s most popular large cap index. Apple, Google, and Amazon are perhaps the greatest innovators of the last decade and are among the world’s largest revenue earners, yet they have no plans to join the Dow.
Leaving America’s greatest innovators and largest companies out substantiates the index as incomplete. The Dow is known as a large cap index, yet its model ironically omits America’s largest companies.
History vs. Reason
With all of its shortcomings and inconsistencies, why does the Dow remain so highly regarded? Nicholas Colas, chief market strategist at ConvergEx, told Fox Business in January that fascination with the Dow starts and ends with history.
“The Dow has one existential advantage: it’s the oldest. Before the Federal Reserve existed you had a Dow Jones Industrial Average,” said Colas. “There’s actual value to that. If you want to understand how stocks traded in the Depression, you’ve got one choice and it’s the Dow.”
Jamie Farmer, managing director of S&P Dow Jones Indices, agrees with Colas. “Extensive history allows for a referential touchstone. We’ve got so much history, the actual number we see provides a great deal of value. We know intuitively where the (Dow’s) number is.”
Although the Dow certainly has a rich history, it’s obvious that the index has lost some of its relevancy and needs to make significant adjustments to its pricing-weighting model. Until that day arrives, investors would be prudent to actively follow the market cap-weighted S&P 500 instead of the Dow to gage market activity.
People have grown used to the Dow dominating financial headlines, but the index just is no longer relevant enough to warrant its current level of financial attention.