Big news this week. The Dow has closed over 12,000. Whoopee.
Sometimes, I am amazed at how incredibly stable certain staples of culture can be, even in the face of overwhelming logic & reason.
One example of this is the continued fascination that people have with the Dow Industrials index. This group of 30 stocks has changed over the years, but dates back over 100 years (1896), ever since Dow & the Wall Street Journal attempted to capture a measure of the “Industrial Strength” of the US Economy.
The problem is, the equation they used to calculate it is nonsensical. Literally.
The Dow Jones Industrial Average is a “price-weighted” index. This means that a $1 move in a $25 stock is worth more than a $1 move in a $10 stock.
This, of course, makes absolutely, positively no sense.
Now, a “market-capitalization-weighted” index, like the S&P 500, makes sense. An “even-weighted” index makes sense. Even some of the cool new “fundamental-weighted” indexes, based on figures like the revenues or cash flows of companies makes sense.
But a price weighted index makes no sense. If a stock in the Dow Jones splits 2:1, it’s future impact on the average will be lower than if it never split at all.
This, compounded with the incredible unpredictable and poor timing that the index owners have used to add & remove stocks from the index has led to extremely unpredictable performance.
There is a really great piece in Business Week that illustrates how ridiculous this index is.
As you may have heard, Berkshire Hathaway, Warren Buffet’s company, hit its own milestone lately by trading at $100,000 per share. Yes, that’s right. The reason it is so high is that they have never split their stock, and it has compounded at extremely high rates since the 1960s.
Can you imagine what the Dow would be like if it had included Berkshire Hathaway as one of its stocks (which would be easy to justify)?
The answer is: if they had added it in 2000, the index would now be at 22000!
Buffett’s Baby: Too Big for the Dow
Despite this, every newspaper and television show seems to highlight this milestone for this nonsensical financial metric. And it really does influence investor behavior. I have family members who have told me they are reluctant to buy stocks right now because “the Dow is so high”.
For the 20 or so readers of this blog, hopefully now you know the truth. Spread the word. The DIA is meaningless.