Last Updated on February 28, 2024
“The Dow dropped 1,000 points!”, screams the television financial reporter.
I don’t know why financial reporters, analysts, and the financial industry continues to reference the Dow Jones. It’s not relevant for many people.
There are more meaningful ways to measure stock market performance and what is happening in the economy than moves in the Dow.
I’d love for the world to stop referencing how many points the Dow goes up or down in a day.
It creates bad habits.
Let’s look at what the Dow is, how it’s created, and, when you say the stock market is up or down, why you need to be specific about which index is up or down.
What is the Dow Jones Industrial Average (DJIA)?
The Dow is a stock market index made up of 30 publicly traded companies in the United States. It was created in 1896, and as you can imagine, life was different back then.
The first 12 companies in the index were American Cotton Oil, American Sugar, American Tobacco, Chicago Gas, Distilling & Cattle Feeding, General Electric, Laclede Gas, National Lead, North American, Tennessee Coal and Iron, U.S. Leather, and U.S. Rubber.
These were influential companies in their day. Each was a titan of their respective industry.
To calculate the index, they would add up the stock prices of each company and divide by 12.
Today, it’s an index of 30 influential companies meant to represent the economy as a whole.
How is the Dow created?
The Dow is a price-weighted index. Bear with me as I get technical for a second because it’s crucial to understanding why the Dow doesn’t matter.
Price-weighted means you add up the stock price of each company in the index and divide by a factor (changes over time based on stock splits) in order to obtain the index value.
The problem with this method is that they are using prices of stock – not the size, or market capitalization, of a company. This means that a stock with a high price is going to influence the index value, even if that stock is a smaller company.
For example, if Company A has a stock price of $500, but the total value of the company is $20 billion, the movement in that stock will affect the index more than Company B, whose stock price is $50, but the total value of the company is $40 billion.
Despite Company B being twice as large, it affects it one tenth as much ($500/$50).
Why should a smaller company with a higher stock price impact an index more than a larger company with a lower stock price?
The actual price of a stock is not as relevant. Below are the current 30 companies in the Dow as of the latest update of this writing, February 28, 2024, along with the last price and weight.
|Unitedhealth Group Inc
|Goldman Sachs Group Inc
|Home Depot Inc
|Visa Inc Class A Shares
|Travelers Cos Inc
|American Express Co
|Honeywell International Inc
|Intl Business Machines Corp
|JPMorgan Chase & Co
|Johnson & Johnson
|Procter & Gamble Co
|Merck & Co. Inc.
|Walt Disney Co
|Nike Inc Cl B
|Coca Cola Co
|Cisco Systems Inc
|Verizon Communications Inc
As you can see, UnitedHealth Group has the highest price, so it is going to affect the index value more than any other stock. Verizon will affect it the least.
In fact, UnitedHealth Group will affect the Dow 12 times more than Verizon despite it only being about 2.7 times larger, according to their market capitalization, or total value of the company. As of this writing, UnitedHealth Group has a market capitalization of about $456.94 billion while Intel has a market capitalization of about $168.23 billion.
Does that make sense to you?
It doesn’t make sense to me.
Price-weighted indices are unhelpful.
Most indices are market-capitalization weighted. Companies that are worth the most impact the index the most.
That makes sense.
Diversification of the Dow
The other issue with the Dow is how the companies are selected.
A committee selects which companies should be added or removed from the index.
Sometimes, companies file for bankruptcy, which then makes them ineligible for inclusion in the index. Other times, a major bank during a financial crisis that received billions of dollars in aid from the U.S. government is removed based on the lack of stability.
The committee looks at a company’s reputation, its history of sustained growth, its interest to investors, and its sector representation of the broader market. They don’t include utilities or transportation companies.
Since the index is not changed frequently, new companies that are becoming industry leaders are not often added until much later. For example, Apple wasn’t added until 2015. In fact, the New York Times Magazine talked about this issue and Apple not being in the index in 2012.
The companies tend to be large, blue-chip companies with plenty of shares available for trading.
Between the Nasdaq and NYSE, there are over 6,000 publicly traded U.S. companies. The Dow only includes 30 based on their price.
In other words, the Dow doesn’t look at smaller companies at all or even most of the large, publicly traded companies within the U.S. economy.
Depending on the time period, the index may not have much exposure to certain sectors of the economy.
In other words, the Dow is not well diversified.
Why the S&P 500 Isn’t “The Market” Either
Although the S&P 500 is a better representation of how the market is doing, it’s still not the entire market.
As of this writing, February 28, 2024, the S&P 500 has 503 companies. The “500” in the name fooled you, right? The “extra” companies are due to some companies having multiple share classes.
Although many people consider the S&P 500 the U.S. stock market, it only represents about 80% of the total value. It’s a good chunk, and much better than the 25% or so the Dow represents, but it leaves out 20% of the value of the U.S. stock market.
It also doesn’t have thousands of companies. If there are 503 companies in the index and over 6,000 publicly traded companies, it only includes about 8% of publicly traded companies.
Many of them are small and don’t impact the market much, but it helps give perspective.
When people talk about “the market” you need to ask the question, “Which market?” Is it the U.S. stock market? Is it the Dow? Is it European markets?
If the people say the Dow is down, remember, it’s only 30 stocks that make up about 25% of the total value of US stocks based on a price-weighted basis. It’s not very helpful.
If people say the S&P 500 is down, that’s a better measure of the U.S. stock market because it’s 80% of the total value of the U.S. stock market, but it still doesn’t tell you how the other 20% is doing or how the thousands of other stocks, mostly smaller companies, are performing.
Alternatives to Assessing “The Market”
If you are wondering what may give a better idea of how all stocks as a whole are performing, you could look at the following indices:
- Dow Jones U.S. Total Stock Market Index
- FT Wilshire 5000 Index
- FTSE US Total Market Index
The key is to find a U.S. total stock market index, which will include close to the 6,000 stocks that are publicly traded. When pundits talk about the market, they may not be referring to these indices, but at least you will know these are better a representation of the total U.S. stock market.
If you want to have an idea of how the entire world stock market is doing, you could look at the following index:
- FTSE Global All Cap Index
It captures about 98% of the world’s investable market capitalization. It includes U.S., developed international, and emerging market stocks. As of January 31, 2024, it had 9,823 stocks from around the world in the index.
Final Thoughts – My Question for You
The Dow is not a good measure of how the U.S. stock market is doing. It only represents 30 large companies in the U.S. stock market.
Since it’s constructed based on a price-weighting basis and not a market capitalization weighting, smaller companies with higher share prices can impact the index more. It’s a poor way to construct an index.
Even the S&P 500 isn’t an entirely accurate representation of how U.S. stocks are doing. It excludes thousands of stocks in the U.S., mostly smaller companies. It leaves out about 20% of the U.S. stock market capitalization.
When the financial media talks about the Dow dropping a certain number of points, remember it is not a great measure. You can look to an all world/global index for a better representation of how the global stock market is doing.
I’ll leave you with one question to act on.
Which index will you remember to look at the next time the financial media references the Dow?