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Fisher Investments MarketMinder:

Don’t Bow to Dow

It’s time investors stopped bowing to the Dow—it’s a poorly constructed index.

Topic:

US Economy

6/2/2009 By Fisher Investments Editorial Staff

Story Highlights:

General Motors (GM) filed for bankruptcy and will be removed from the Dow Jones Industrial Average index, along with Citigroup.
The market seemed to little mind GM’s bankruptcy filing and Dow removal, but what does the Dow shake-up mean for investors going forward?
Investors shouldn’t pay attention to the Dow—it’s a poorly constructed index.

(Editor’s Note: Fisher Investments MarketMinder does NOT recommend individual securities; the below is simply an example of a broader theme we wish to highlight.)
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It’s bye-bye to General Motors (GM), and we don’t just mean its Chapter 11 bankruptcy filing. As of June 8, 2009, the company will also be removed from the Dow Jones Industrial Average index, along with Citigroup. GM’s bankruptcy filing automatically disqualifies it from inclusion in the Dow, and Citigroup’s ongoing restructuring will see a government stake that’s too large for comfort for the Dow committee. Cisco Systems and Travelers will join the Dow in their places.

The market seemed to little mind GM’s bankruptcy filing and Dow removal—the S&P 500 ended Monday’s trading session up 2.6% . Who would have thought an American icon would suffer such a fall, and the market would do fine? (Well, besides us.) But what does the Dow shake-up mean for investors going forward? Very little actually, because the Dow is a poorly constructed index. In fact, our team at Fisher Investments MarketMinder has always emphatically stated investors should never pay attention to the Dow.

Yes, the Dow is likely the most widely recognized and cited index when talking about the US stock market. But it’s neither a good representative of US stocks nor its economy. What do we mean? First, the Dow’s size is limiting. There are only 30 active companies in the Dow at any time—hardly a fair and total representation of all US stocks. Second, companies are added to and dropped from the Dow either because of some arbitrary rule (e.g., bankruptcy) or by subjective reasons determined by a committee of Dow Jones editors (e.g., Citi)—not by precise metrics. Third, and most important, the Dow is a price-weighted index.

In price-weighted indexes like the Dow (and, incidentally, Japan’s Nikkei), the higher the price per share of a stock, the more impact its performance has on overall index returns—even though a lower-priced stock can be worth more and be bigger than a more expensive stock by any standard. This can greatly skew performance. For example, both 3M and General Electric are currently included in the Dow. Both are household names and have been around for over 100 years, but GE is a much larger company by revenue, employees, and market cap (3M has a market cap of $41.2 billion, and GE $146.8 billion). But at $59.3 a share, 3M’s stock performance influences the Dow more than four times GE’s stock, which trades at $13.9 a share. Is 3M more indicative of US stock market and economic health than GE? Four times more indicative? Hard to say. (Fisher Investments MarketMinder is doubtful.) But that’s what the Dow’s performance reflects.

So why the Dow mainstay through all these years? Mainly for sentimental and cultural reasons. Still, those aren’t good rationales for paying attention to its performance and component shifts, or using it as a portfolio benchmark. Instead investors should use broad, market capitalization-weighted indexes like the S&P 500 for US stocks and MSCI World for global stocks. Market cap-weighted indexes give weight to companies based on the values of their total shares outstanding. It makes intuitive sense. Now, if there was only an arbitrary rule that removed the Dow Jones Industrial Average from the investing landscape.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

Comments
The following represents commentary by Fisher Investments' staff members on the content of the foregoing article. All comments are subject to the full disclaimers of the MarketMinder.com website located here.

16 Comments

Misleading...
Added by ashmuth on 7/29/2009 2:30:54 PM
There has been quite a bit of media hype about the Dow of late and it reaching 10,000. But in my opinion, such arbitrary milestones are meaningless. For more on this, I would suggest reading the 07/24/2009 cover story, "Misleading Milestones."

Global Index All the Way
Added by evec on 7/17/2009 3:29:07 PM
I agree with ashmuth--a global index is a much better interpretation of today's investment world, in my opinion. Yes, the US is big, but it no longer truly dominates the globe. There's a reason why eliminating trade barriers is becoming increasingly important; people realize our world is becoming increasingly intertwined. I believe holding on to the Dow as a measure of how the US (or even the world, in some cases) is doing is simply flawed.

Better alternatives
Added by ashmuth on 7/8/2009 3:37:57 PM
People do a lot of things based upon sentimental and cultural reasons. But in my opinion, benchmarking your portfolio against an index that was introduced ages ago (before there was realtime index pricing as EBA points out) is just crazy. As with most things, better alternatives to similar concepts are created and this is the case with the Dow--in my opinion, investors these days should be using a global index.

Every dog has its day
Added by jd on 6/29/2009 2:55:59 PM
The Dow is definitely outdated. There was a time it was one of the only options for following stocks--and in fact, a fairly innovative one, all things considered. Before the Dow, investors had few consistent and widely available methods for following stocks. And because the stock market was much, much smaller, fewer companies might have been more representative then. But none of that excuses its major flaws today. Since its creation, index construction has advanced leaps and bounds, and the US stock market has expanded mightily (not to mention the global market, as asmuth and evec rightly point out!). As a Fisher Investments employee, I think there are better options out there. The Dow just doesn’t cut it anymore. Pretty much everyone but the media gets that. Every dog has its day, but that's no reason the Dow should stay.

Dow and Daily Movements
Added by evec on 6/26/2009 2:49:34 PM
I think it's foolish how the Dow's daily movements are tracked so closely by so many. What does the Dow really stand for anyway? (Well, it's 30 stocks, but that was a rhetorical question.) Point is, the Dow doesn't accurately reflect the health of the US or the global stock market. I believe it's important to remember that.

An ailing index
Added by ashmuth on 6/24/2009 3:48:45 PM
I completely agree with evec. I think it makes much more sense to follow a global index instead in today�s world. Global trade is alive and well, so why wouldn�t you track a global index? In my opinion, it doesn�t even make sense anymore to look at an index such as the Dow.

Dow Is Flawed
Added by evec on 6/19/2009 3:36:03 PM
As a Fisher Investments employee, I cringe a little when I hear morning newscasters announcing the Dow's movements. What I've learned is thinking that a mere 30 stocks is an accurate representation of the US stock market is absolutely foolish. I believe it's best to stop following such a limited index and start tracking a more global index--after all, the world is becoming more intertwined due to increased trade and travel among countries.

Outdated
Added by ashmuth on 6/17/2009 2:57:29 PM
As a Fisher Investments employee, I don't lend legitimacy to an index just because it's well-known. Recently, GM and Citigroup were both dropped from the Dow and replaced with Cisco Systems and Travelers. Why not get rid of the index all together? Simple, the Dow is popular and the name resonates with investors. Despite being outdated, I wouldn't expect this index to disappear for quite some time. But I think there are much more relevant indexes out there for the modern investor to use as a benchmark.

No More Dow
Added by evec on 6/12/2009 1:57:47 PM
I believe the Dow is still around purely for nostalgia's sake, but when has nostalgia ever made anyone money? (Except for collectibles, but that's something else altogether.) Using the Dow as a way to gauge the economy and/or stock market is a bad idea in my opinion, and the Dow should not be allowed such prominence in financial news or anything related to the markets.

Arbitrary Dow cont.
Added by ashmuth on 6/10/2009 1:25:40 PM
I agree with CRF…removing companies from a benchmark shouldn’t be so subjective and only makes me question the Dow’s accountability even more. In my opinion, I think it’s better to look to a market-cap weighted index as a better benchmark to track movement.

Dow Origins
Added by EBA on 6/2/2009 5:31:34 PM
The Dow began as a quick way for traders to figure out if the broader market had gone up or down in the course of a given trading day.... back in the early 1900's! Before there was realtime index pricing, this was a fast manual calculation. The fact that it's still around is laughable.

I don't care about the Dow
Added by ashmuth on 6/2/2009 4:31:19 PM
I agree with evec, I don't think the Dow is a reputable index and is definitely flawed. Also, I find it odd when the Dow is experiencing highs investors believe it to be a legitimate index. But if the Dow heads south and investor portfolios are outperforming vs. the Dow then all of a sudden it isn’t legitimate anymore? How could an index with such a small representation of stocks ever be a good comparison for anything? As a Fisher Investments employee, I believe there are far better indices out there.

Arbitrary Dow
Added by CRF on 6/2/2009 4:27:22 PM
A lot of investors were questioning why Citigroup and GM weren't removed from the Dow sooner. The same sort of questioning happened with AIG. If a benchmark index is being questioned, then that shows it's flawed. Adding and removing companies from the benchmark shouldn't be a subjective thing, based on the opinions of a Dow committee, but on standardized metrics. With market-cap weighted indexes, the metrics are clear and clean-cut.

All this hoopla surrounding the Dow is....just hoopla
Added by evec on 6/2/2009 4:24:32 PM
When GM and Citi were taken off the Dow, it caused a media firestorm. My opinion? Big deal. So what if the two companies were taken off the index? Yes, the Dow is still tracked by many to gauge the health of the US economy, a fact that boggles my mind. As a Fisher Investments employee, I believe placing so much emphasis on one inherently flawed index isn't a smart move.

Is the Dow good for anything?
Added by LRD on 6/2/2009 2:15:19 PM
This article makes some excellent points why the Dow is poorly constructed. As a Fisher Investments employee, I tend to agree the DJIA falls short of being a valuable benchmark. Are there any redeeming qualities? Despite its blatant flaws, I know lots of people pay attention to it. From my perspective, the Dow clearly isn't very representative of broad US equities, but I'm curious if the Dow might be reflective of investor sentiment. Any thoughts?

Who cares about the Dow?
Added by evec on 6/2/2009 10:53:16 AM
Not me. As a Fisher Investments employee, I believe the Dow is an extremely flawed index, as explained in this MarketMinder article. In this day and age, it makes no sense to put so much emphasis on an index that tracks only 30, US-only stocks. That's ridiculous, considering there are a lot more than 30 stocks in the US alone--not to mention the world is becoming increasingly global. I definitely won't be making the mistake of using the Dow to track market movement.