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Most things developed in 1896 don’t get a ton of attention anymore. The world of 1896 is one where Russia has a czar, women aren’t allowed to vote, one of the Presidents currently on Mount Rushmore is still five years from taking office, and the Chicago Cubs still have two World Series titles in their future. Yes, their FUTURE.
However, at least one invention of 1896 continues to be a part of everyone’s daily ritual: the Dow Jones Industrial Average. Debuting with just 11 stocks in 1885 in the Customer’s Afternoon Letter, it was the brainchild of Wall Street Journal-founder Charles Dow and statistician Edward Jones. After becoming the Dow Jones Industrial Average (DJIA) on May 26, 1896, the DJIA would go on to become one of the very first stock market indices and revolutionized the way people perceived the stock market.
However, despite a long, storied history and a prominent place in the formation of the very markets we all depend on today, it’s time to lay this relic to bed. The markets long ago outgrew the DJIA and the only reason we still get daily updates about it from every major news outlets is little more than laziness.
So, why not make a change? Who is it that’s defending the DJIA? Why not push to remove this relic from our public consciousness and let other, more-deserving indices take its place? I, for one, can’t think of a particularly good reason.
Understanding Indices
No index is perfect. Nor is any one going to paint a clear picture of the entire economy as many have come to believe the DJIA does. Each index is a snowflake, presenting a numerical representation of a specific segment of the broader markets.
Soaring stock prices don’t necessarily mean the overall health of the economy is good. Nor do plunging prices necessarily mean hard times are coming. It’s hardly the fault of the DJIA that it’s become a go-to representation of the economy for news organizations looking to skim over the day’s business news.
What’s more, it would be a serious mistake to underestimate just how important the DJIA was in revolutionizing stock market participation and perception. Where the movements of the market were once impossible to discern for any aside from the most seasoned market watchers, there was now a single index that could give everyone a general sense of how the biggest names in the market had performed. It helped a much broader swath of the American population understand enough about the markets to consider investing in them and represented a sea change.
One Well-Deserved Reputation Does Not a Strong Indicator of Equities Markets Make
However, being the first into the space hardly means you’re the best. In fact, the opposite is typically true. While an innovative and revolutionary product at its debut, we definitely aren’t still driving Model Ts.
For starters, while there are over 5,000 publicly listed companies in the United States of America, the Dow Jones Industrial Average only represents 30 of them. That’s a little over a half percent of the total. And, while one might assume that being so incredibly selective about which companies get to represent the entire market for American stocks would mean the selection process would be incredibly sophisticated, it’s not. The companies on the DJIA are selected by the editorial board of the Wall Street Journal, an offshoot of the index being created by the paper’s founder.
So, the DJIA is just a list of the 30 “most important” companies in America selected, not by seasoned economists or top-level mathematicians, but by financial journalists. It’s entirely too small to precisely reflect the stock market as the fact that it has only 30 companies means a particularly good or bad day for any one of them can swing the index.
Price-Weighting is a Totally Arbitrary Method for Calculating an Index and it Needs to Stop
The original methodology for calculating the number of the Dow Jones was to take the average price of a single share of stock across the companies included in the index. Kind of makes you wonder what, exactly, statistician Edward Jones’ role in all this actually was.
However, it doesn’t make any sense.
The total number of shares that make up a company’s stock, it’s “float,” can change at pretty much any time. And those changes alter the share price without actually changing a thing about the company itself i.e. the same pie can be cut into four pieces or eight pieces or even 16 pieces (though, at that point, just get a second pie) and, while each new division creates slices of different sizes, the size of the actual pie hasn’t change a bit.
Companies can (and do) create new shares to sell to the public and raise more money, or they buy back shares as a way of distributing profits to investors. They can “split” their stock, doubling the size of the float and cutting the share price in half to make it easier for people to buy and sell shares. They can also do a “reverse split” where they destroy half their existing float to double the price of shares, usually in hopes of decreasing volatility by making it harder to execute trades.
Any public company’s board of directors can vote to do any of these things pretty much whenever they want. And, while the DJIA has constantly altered its calculation to reflect these changes, it doesn’t change the fact that share price is ultimately not representative of the actual size of the company.
On the DJIA, a company worth $100 billion with 1 billion outstanding shares is ultimately given the same weight in the DJIA as a $100 million company with 1 million outstanding shares despite the latter company being just one tenth the size of the former.
The simple reality is that share price is a totally arbitrary metric to weight an index with. This should be clear from the one major reason why Charles Dow even used price-weighting in the first place: it was the only reliably available data on securities in 1896. He price-weighted his index because he couldn’t really do anything else as companies weren’t required to publish the size of their float back then. Which makes price-weighting a perfectly pragmatic compromise for the late 19th century and an utter absurdity in the 21st.
Dismissed by the Knowledgeable Investor
And that is why virtually everyone who actually associated with the markets doesn’t give a hoot about the price performance of the DJIA aside from its effect on the general public’s perceptions of the markets.
The S&P 500 is clearly the winner of the two for professional fund managers or seasoned investors. It’s far from perfect. In fact, it’s imperfect in a lot of similar ways to the DJIA, but it’s still superior in its methodology at almost every turn.
For starters, the fact that it includes more than 16 times as many companies alone makes it a far better representation of stock markets. That’s still a pretty skimpy sample size (just about 10 percent of publicly-traded companies), but it’s a world of difference from the Dow. The S&P 500 contains about 75 percent of the available “market cap,” the collective value of a company’s stock, throughout publicly traded stocks compared to about 25 percent for the DJIA. And the combination of that much more total equity and 470 additional companies means no one company’s performance will sway the S&P 500 in the way that they can the DJIA.
The S&P 500 is also selected by a committee, but it’s a committee at Standard and Poor’s, which employs a publicly available set of criteria involving liquidity and market cap that a stock must meet before being considered for inclusion. So, while one might assume that an index trying to select 30 stocks to represent the performance of 5,000 public companies would be more meticulous in its process than one selecting 500, the opposite would appear to be true.
And finally, and this is the really important one, the S&P 500 is market cap-weighted. So, the fact that Apple (AAPL) is worth roughly twice as much as JP Morgan Chase (JPM) on the open market means that price movements for Apple affect the S&P’s overall performance about twice as much as JP Morgan’s do. Which makes a ton of sense.
These are just a few of the reasons why actual investment professionals have little to no interest in the DJIA. For proof, one need look no further than the top traded ETFs on the market. The single security with highest average daily volume is the SPDR S&P 500 Index ETF (SPY) , which is constructed to mimic the performance of the S&P 500, moving more than 120 million shares a day.
The SPDR Dow Jones Industrial Average Index ETF (DIA) ? Just an average of 7.7 million shares a day. For those investors interested in passive investment, the DJIA is barely a blip on their radar.
Plenty of Other Options
And, of course, it doesn’t stop there. There are still other indices that perform in ways that would appear to improve on the S&P as well. The Russell 3000, for instance, is a cap-weighted index, too. But, it’s also selected purely by criteria, including the 3,000 companies in America with the highest market caps, thus eliminating any degree of human bias in the selection process.
For those of you pointing out that these indices using market price for stocks will ultimately reflect the stock markets, which are rife with speculation and unjustified valuations for companies yet to make any money, there are indices out there that weight stocks based on actual corporate profits. And for still others screaming that corporate profits and stocks aren’t reflective of the broader economy, there are even indices that don’t even measure stocks, looking to economic data instead.
Time for a Change
The point is, while there’s likely never going to be any one perfect index that will paint a complete picture of the entire stock market, let alone the entire economy, the Dow Jones Industrial Average may actually be one of the worst options available. Which makes it all the more frustrating that it’s so often presented as such.
While the S&P 500 has plenty of its own warts, it’s unquestionably a better-constructed index. So why does the DJIA persist? Little more than tradition.
Consider the QWERTY keyboard that we all know and love (and that this article is being composed on). The QWERTY keyboard was designed to separate the most-used letters from each other so that typists using a typewriter wouldn’t have to worry about the keys sticking, an issue if you typed too many letters nearby one another.
This is, however, not a serious concern with a computer. And better keyboards have been invented, including the Dvorak keyboard used to set the record for the fastest typing rate. Why do we still stick with QWERTY? Because everyone would have to learn how to type all over again and we would all rather put up with typing 20-30 words per minute slower than go through that hell.
However, it’s not as though people’s familiarity with the DJIA extends to actual working knowledge. Ask a random person on the street how a company gets into the DJIA or how many stocks are in it or what those numbers actually mean and you’re likely to get a blank look. And anyone who can answer these questions probably already ignore the DJIA.
So, what’s to stop us from making the switch other than just speaking up? If the only reason we still get the DJIA crammed down our throat every day is by force of habit, doesn’t that mean we could make that stop? Why don’t we start writing angry letters to our news providers asking that they update their standards? People will do almost anything to stop getting strongly worded letters.
So, I put it to you, let us rise up against the tyranny of the Dow Jones Industrial Average. Investors of the world unite, you have nothing to lose but your grossly outdated and obsolete stock market index!