The Dodgy Dow

Client: I recently read that the Dow Jones Industrial Average is nearing its all-time high? What does this mean to me?

The easy answer is "not much." While it is true domestic markets have been on a tear during the past few months, I generally recommend that my clients pay no mind to how the Dow performs, since it is almost completely useless when it comes to evaluating the performance of the market.

Why? The Dow Jones Industrial Average, or Dow for short, is a poorly constructed, often misleading index that, despite its popularity, really does not provide investors with an accurate barometer for the performance of the broader markets. There are far better options available.

Client: What exactly do you mean by "poorly constructed?"

The Dow is just an arbitrary collection of 30 stocks that have no relation or connection to the broader marketplace. It makes no effort to accurately represent the overall equity markets, which makes it confounding that so many investors view it as an appropriate proxy for the performance of the U.S. stock market.

That is just one complaint. Perhaps more importantly, the Dow is price-weighted. What's wrong with a price weighted index? The problems come in the calculation of the level of the index. When you look at the weighting of the individual components of the Dow, it gives the most weight to those companies whose share prices happen to be the highest. For instance, look at 3M and General Electric, two companies currently in the Dow. Recently, 3M, which has a market capitalization of about $60 billion, had a share price of about $80. General Electric, which has a stunning market cap of over $360 billion, had a share price of $35. In terms of their effect on the Dow, 3M has more than double the influence than General Electric, despite being about 1/6 the size. That doesn't make much sense.

Client: If it is so poorly constructed, why does my broker always talk about it? I see it in every single financial publication, too. It's even on the nightly news – it can't be that bad, can it!?

For the most part, continued reference to the Dow in the popular media is just a case of sentimental historical bias. The Dow Jones was created by Charles Dow in 1896, so for all but the oldest of folks, it has been around for just about every investor's entire life. It has always been flawed, and the continued reliance on it as an indicator is really just a reflection of society's resistance to change something that has been in existence for so long. The fact that the company who runs the Dow also sponsors The Wall Street Journal probably doesn't hurt either.

Client: OK, so give me an example of an index that I should be using.

I would recommend using a broad-based, market capitalization-weighted index. In indexes such as these, the individual components are weighted according to their relative size in the marketplace. Using the GE/3M example from above, GE would have a far greater influence on a market cap-weighted index as compared to 3M because it is a much larger company.

There are many examples of "good" indexes. If you're solely interested in investing in U.S. companies, you may choose to look at the Standard & Poor's (S&P) 500 Index. For global investors, the Morgan Stanley Capital International (MSCI) World Index or the MSCI All Country World Index (which includes a weighting to emerging markets) may be better options. All of these indices are cap weighted, very broad, and will tell you far more about the state of the market than the Dow.

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Each week The Advisor's Corner tackles a common situation or issue facing financial advisors and their clients.