The Dow AKA the Dow Jones AKA the Dow Jones Industrial Average AKA the DJIA is one of the least useful indicators in the world.
It is also one of the most watched.
A List of DJIA Allegories
- If the Dow Jones was a song, it would be a Britney Spears featuring Pitbull number. Super trashy, weird falsetto rapping, with indiscriminate lyrics but mass appeal.
- If the Dow Jones was a type of food, it would be a sugar pill. Wasted tasteless carbohydrate that turns immediately into a lifetime on the hips.
- If the Dow Jones was a drink, it would be a decaffeinated soy cappuccino. Because it only looks good, although it’d be sanctimonious about it in your face.
- If the Dow Jones had an online dating profile, the silicon would be on full display to attract the highest bidder.
That was fun.
But the truth is, even the S&P Dow Jones Indices people, who compile the DJIA, don’t think it’s much good.
So let me explain why.
What is the Dow Jones?
Back in 1896, the New York Stock Exchange was not a huge stock exchange. So when Mr Dow was inventing an index to give people an average idea of how things were going, it didn’t require too much thought. The thought process must have gone something like this:
- Let’s take the share prices of the 30 largest companies (or, like, the important ones)
- Add them together
- Divide by 30
Since then, not much has changed.
Today, the index compilers are still taking the share prices of the 30 companies picked by the selection committee, and then dividing by the number of companies to get the index. Admittedly, they’ll adjust that divisor to take into account share splits, etc – but that’s really just to maintain the comparability of the index against itself over time. The principle is still exactly the same.
What’s Wrong With That Method?
You mean – apart from the fact that it’s only taking into account 30 companies chosen at random?
- Let’s assume that there are only two companies in existence. Company A represents 90% of the market, Company B represents 10% of the market.
- The share price of company A goes up by $10.
- On the very same day, the share price of company B goes down by $10.
- What would happen to the DJIA? It would remain unchanged (the $10 gain of A offsets the $10 loss of B exactly).
- But 90% of the market made $10 that day!
- The DJIA does not care.
- The DJIA remains unchanged.
And let me make that point clearer:
- Let’s say that it’s the same scenario, but the share price of company B dropped by $20.
- What would happen to the DJIA?
- It would go down.
- On the day that 90% of the market made a return…
So the first part of the DJIA’s problem is that its a market index that pays no attention to the market.
Another Problem, If That Weren’t Bad Enough
Here’s another example:
- Still assuming that there are only 2 companies in existence, let’s say that Company A is worth $100 million and Company B is worth $100 million.
- But for whatever reason, Company A has decided to form itself as 100 million shares, where Company B has decided to do it with 20 million shares.
- What does this mean?
- It means that the share price of A is $1 per share, and the share price of B is $5 per share.
- All good so far.
- Let’s say that the market is exuberant one day, and it decides that Company A is worth double what it was yesterday.
- What happens to the A’s share price? It goes up by $1 to $2.
- In total, the market is worth $100 million more than what it was yesterday. That’s a 50% increase, which is excellent news!
- What would the Dow say?
- It would say that the index was 3 yesterday*, and it went up to 3.5 today**, and that therefore, the market is up ±17%…
*($1 + $5) ÷ 2 = 3
**($2 + $5) ÷ 2 = 3.5
Not ideal – especially if you flip the situation so that the market was exuberant about Company B instead. In that case, the Dow would go from 3 yesterday up to 5.5* today – or an 83% increase!
*($1 + $10) ÷ 2 = 5.5
An index that gives two different values for the exact same overall market movement?
So Why Do We Still Have It?
Because it’s old. Heritage and all that. Oh – and not everything has to be useful.
So try not to use it…