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Using the right index

It often surprises newer investors to learn that the Dow Jones Industrial Average (DJIA) is largely ignored by most market participants. The Dow results still get reported on the nightly news, so why is it shunned?

Here's what I wrote about the Industrial Average in a May 2009 article (subscribers' link) in the Sound Mind Investing newsletter:

Although this is the best known of all market indexes (and the one that gets the most attention in news reports), "the Dow" is actually the least useful major index.

A significant problem is that it measures the performance of only 30 specific companies. While these 30 are selected carefully to reflect the fortunes of the general economy, a sampling of 30 stocks simply can't be as accurate a barometer of large-company performance as an index that includes hundreds (or thousands) of stocks.

The fact that the Dow is price-weighted (higher-priced stocks have more influence than lower priced ones, regardless of market capitalization) also hinders its usefulness.

I came across a perfect example of these problems last week on the Bespoke Investment Group site. They noted that back in June 2009, the keepers of the Dow replaced General Motors with Cisco, one of the nation's largest technology firms.

Replacing an auto manufacturer with a premier technology company wasn't what got people talking about that move. Rather, it was the debate over whether Apple should have been added rather than Cisco.

How big a difference would that substitution have made? Would you believe 1,000 points in less than two years?

When dealing with an index of so few stocks, such cases aren't as difficult to find as one might suspect. A couple of years ago, investment researcher Norman Fosback pointed out that the Dow would be roughly twice as high today had IBM not been removed from the index in 1939.

The DJIA's narrow focus is the primary reason most modern investors look to other indexes. The S&P 500 is probably the most widely followed today. However, at SMI we prefer the Wilshire 5000 (PDF), given that it represents the performance of roughly 99% of the U.S. domestic equity market.

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