The Dow Jones Industrial Average (or ‘the Dow’, ^DJI, DJIA), is a stock market index created back in 1896 by Charles Dow, a journalist. The goal of the index is provide a view of the stock market’s health. The Dow is an index of just 30 (arbitrarily chosen) stocks, weighted by the stock prices of its component companies and nothing else. To calculate, simply add up the 30 stock prices and divide the total by the Dow Divisor. When the index was formed, the divisor was 30, but after over 100 years of compenent changes, dividends, and stock splits, the Dow Divisor is around 0.14602128057775. The Dow is the most cited and most widely recognized of the stock market indices, and below I’m going to walk through why it’s completely meaningless.
At the highest level, the Dow is not the best represenation of stock market performance, simply due to the low (30) number of companies included in the index. However, in addition to only covering 30 companies, the Dow is weighted on company share price, not market capitalization (company valuation) as it should be.
The Dow is weighted on share price, not market capitalization
As mentioned above, the Dow simply adds up the share prices of its 30 companies, and divides by the Dow Divisor. This means that a given company can have an influence on the index disproportionate to its actual value. Market capitalization would be a better way to weight each company’s influence in the index’s movement, since it provides the actual value of a company traded on the stock market, calculated by multiplying share price by total outstanding shares.
To give an example, say a fictional company, ‘Corporate Synergies’, has a per share price of $100, but only 10 shares outstanding, meaning a market capitalization of $1,000. Next, lets say another fictional company, ‘Leveraging Innovation’ has a per share price of $10, but has 900 shares outstanding, meaning its market cap is $9,000. Now, in this example the weighting of these companies should be:
- ‘Corporate Syngeries’: ($1,000 market cap)/($10,000 total market cap in index) = 10%
- ‘Leveraging Innovation’: ($9,000 market cap)/($10,000 total market cap in index) = 90%
However, applying the price-weighted methodology used by the Dow, we arrive at basically the opposite weighting:
- ‘Corporate Syngeries’: ($100 share price)/($110 total share price in index) = ~91%
- ‘Leverage Innovation’: ($10 share price)/($110 total share price in index) = ~9%
So, as we can see above, since the Dow relies on share price weighting to move the index, lower value companies can be overrepresented, and higher value companies can be underrepresented — remember, market cap = company value.
Now that we’ve gotten through the basic argument along with a small example, here’s a chart showing the weighting of each company in the Dow by share price (incorrect, but used in Dow) and market cap (correct, not used). As you can see, there are in fact many grossly misweighted companies in the Dow today.
So, next time you hear someone talk about the Dow in any serious sense, kindly point them in the direction of an index weighted by market capitalization (e.g. S&P 500 or Wilshire 5000), that consists of more than 30 chosen companies. Together, we can stop making one of the most meaningless stock market indices the most widely cited.
If you’re interested in the specific companies in the Dow, and the associated weights, check out the table here.
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