The Downside Of The Dow Index
Updated: May 3, 2020
Whether we are discussing investments or life, performance should always be measured against a benchmark, otherwise progress cannot be assessed. Investment portfolio performance is sometimes mistakenly benchmarked against the Dow Jones Industrial Average (DJIA), or simply the Dow. Those who use the Dow as a performance benchmark are often misguided and misinformed.
The Dow is a well-known stock market index that is based on the value of 30 publicly owned companies in the United States. It is the second-oldest U.S. market index - first calculated in 1896 by then Wall Street Journal editor Charles Dow and his associate Edward Jones. The Dow’s main appeal is that it provides over 100 years of historical data to benchmark stock performance. It could be argued that its shortcomings are due to its lack of foresight into how the investment landscape would develop. Business media has used it for so long that they have created the impression that it is a proxy for the overall market. Its main drawbacks are:
1. It is not an accurate representation of overall stock market performance
First, the index contains only 30 companies - not enough to capture the performance of the “stock market”. Also, the Industrial portion is largely historical, as of today only 24% of the modern 30 constituents have to do with traditional industries. In fact, the components of the Dow have changed 52 times since its inception to better adapt to reality. For example, General Electric had the longest continuous presence beginning in 1907 and ending in 2018. Because of its failure to accurately indicate what is really going on in the market, the Dow is rarely used by institutions to benchmark stock performance.
2. The Dow is a price-weighted average index, meaning weight of each component is based on the stock’s price.
The index construction method is flawed as it gives higher priced stocks more influence over the average than their lower-priced counterparts. It doesn’t consider the relative industry size or company value of the constituents. For example, the weight of Travelers Companies Inc. (TRV) is three times larger than Coca-Cola Company (KO) while being 5.5 times less valuable. Originally, to calculate the Dow index, the share price of the components was added and then divided by the number of constituents. Overtime, the divisor had to be adjusted for stock splits to ensure that such events did not alter the numerical value of the Dow.
At Northland Wealth Management we prefer to use market value weighted benchmarks such as S&P 500 in the U.S. or S&P/TSX Capped Composite Index in Canada. The type of clients we serve often are more concerned about meeting future expenses and maintaining their lifestyle, therefore we use the Asset Liability Management (ALM) approach where our goal is to earn the rate of inflation plus anywhere between one to five percent. Calculating performance is imperative and the key is to compare it against the appropriate relative measure to meet client’s objectives.