Fisher Investments Editorial Staff
US Economy

Don’t Bow to Dow

By, 06/02/2009
  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.

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