Relevant episode of Planet Money:<p><a href="http://www.npr.org/sections/money/2017/01/04/508261371/episode-443-dont-believe-the-hype" rel="nofollow">http://www.npr.org/sections/money/2017/01/04/508261371/episo...</a><p>"It's no secret that we here at Planet Money think the Dow is a terrible economic indicator. We don't like that it only looks at thirty companies. We don't like the way it does its math. We think it does a bad job reflecting the overall economy. Honestly, we're not sure why everyone is still talking about it."
The DJIA is just the sum of 30 stock prices, divided by a "divisor" which is adjusted to keep the value constant when a company is added or removed. The amazing thing is that it's quite useful. But why?<p>One reason is a long-standing tradition that stocks should be priced in the range 10 to 100. This tradition stems from old ticker system limitations, and it's weaker than it used to be, but it still has some force. Stocks which get well above 100 usually split (yes, there's BRK), and stocks which get below 10 are usually considered to be in trouble. Below 1, they're called "penny stocks" and get delisted from the big exchanges.<p>As a result, successful companies tend to be near the top of the 10-100 range. This weights them higher in the DJIA. Right now, here's the list.[1] Goldman Sachs is the only one above 200, and they really ought to split. They might get replaced in the DJIA if they don't. Nobody is below 10; GE, at 23, is at the bottom.<p>[1] <a href="http://money.cnn.com/data/dow30/" rel="nofollow">http://money.cnn.com/data/dow30/</a>
>So, next time you hear someone talk about the Dow in any serious sense, kindly point them in the direction of an index weighted by market capitalization (e.g. S&P 500 or Wilshire 5000),<p>The most commonly used index - the one that is shown in the news or discussed with your Uber driver. should be index that provides essential information for the average person.<p>I would advocate pointing people towards total return indexes of S&P 500 or Wilshire 5000. Index's total return displays a more accurate representation of the index's performance than price index and it can be used directly to benchmark stocks to other investments.<p>Surprising amount of people are not aware that stock price index is not accurate measurement of stock market performance over longer periods of time.<p><a href="http://imgur.com/a/uHRZ9" rel="nofollow">http://imgur.com/a/uHRZ9</a>
I wouldn't go so far as to call it useless - anachronistic perhaps, but useless no.<p>When the Dow was first calculated, real time market capitalization for individual companies wasn't a thing.
Prevailing market price was a decent enough proxy that Charles Dow could make an index of leading industrial firms out of prices (and price changes) alone.<p>As others have pointed out, over a long enough time period the Dow Jones has a high correlation with market cap weighted indices. Its annual volatility has been about 1.5 percentage points more a year, but average returns over any reasonable holding period are barely different than, say, the S&P 500.<p>There's an even better argument against the Dow than the price weighting though - the somewhat arbitrary company inclusions. One of the more interesting pieces of history is IBM's 40-year 'vacation' from the Dow. If IBM had stayed in for the 40 years after 1939 you could tack on another 5 figure number to today's index price.
It's not ideal but to call it useless is arrogant and immature. It's a decent indicator of how the blue caps are doing in the markets. SP500 is arguable better but the DJI isn't useless.
That's the reason why Berkshire Hathaway is out of the index, while based on the market cap, it should clearly be in (~400B).<p>That being said, the correlation between DIJ and S&P is close to 100% so for all practical reasons (from a long term investor point of view) it should be OK.
I see a couple of problems with these arguments. First, the assumption that market capitalization is more important for weighting a market index than share price. I'd argue that if your goal is to measure the health of the overall stock market, companies that control the most money should be weighted not much more than less valuable companies. Just because Wal-Mart, Amazon, and Costco are doing great, doesn't mean that JCPenny, Macy's and smaller retailers that employ hundreds of thousands of people are doing great. Giving more weight to smaller companies introduces more companies than just those at the top of the value spectrum. A company with massive resources can probably weather certain negative economic variations better than smaller companies, so to focus solely on those to the exclusion of all others seems to be willfully ignoring a significant part of what comprises the overall market.<p>The other issue is that even though the S&P is cited as being a much better index to track the market, the fact is that the Dow and the S&P correlate almost identically historically. So even if the Dow is reasoned to be much worse than the S&P, history shows that they both reflect basically the same thing.
I guess all the Dow futures and options traders should just pack up and go home? Dow trading is as useful as any index with volume in analyzing herd behavior. It's a far better prospect than analyzing any of it's individual components in isolation.
Not so useless: you can construct hadge fund-like trading strategies with the DOW and SP500.<p>Both DOW and SP500 have some tendency to go up and down at the same time in bull and bear market times.<p>When this happens you can (for instance) short DOW and long SP500 and your losses in the sort side will be covered by the gains in the logn side...<p>...but they will be uncorrelated for short periods of time. So, if your short possition goes down while your long is constant or goes down <i>much slower</i> than your short, then you're making money.<p>Probably you can make this kind of hedging with very little money (or almost free) using the fee you get from going short to buy the long leg of the spread.
Ive heard similar complaints for years and it makes sense to me - what doesn't is why alternatives arent used or created? I don't understand everything about stock markets or certainly their politics but it seems on the surface that if you had a better indicator of the economy itd be pretty easy to show its usefulness. And with historical data you should be able to replicate a new index and measure its effectiveness.
tldr: The Dow 30 index is a bit absurd, however it's not as bad as it seems because of portfolio theory.<p>The Dow 30 correlates highly with the S&P500 index over medium-long periods of times (approx more than a month) [1]. This correlation is due to the fact that the 30 stocks that are selected are arbitrary but not random. They are selected by a human process which considers which companies contribute an important factor to the overall market [2]. Of course this process will be imperfect because it's vague, however it gets pretty close.<p>Don't forget, according to findings from portfolio theory, it's possible to replicate an index with only a small subset of the components of that index [3]. There's a whole field of work describing how to do this [search google for 'replicating index'],<p>In fact, replicating an index with a small number of stocks is exactly how 'smart trading' companies like wealthfront and bettermint make money. They find multiple non-overlapping subsets of the S&P500 which correlate strongly with S&P500 performance. Then they buy subset A, and if a loss is incurred in any month, they sell subset A and buy subset B. Since A and B are highly correlated with each other (ideally r>.99) and with the S&P500, the investor should expect the same return in the future, however can book a capital loss which creates a tax refund. Shifting from subset A to subset B avoids a wash-sale allowing the capital loss to be recognized [4].<p>The Dow 30 is certainly not an optimal index, however it's a case study in showing how selecting the "top" companies for some reasonable definition of "top" will earn a return approx. equal to the market (represented by S&P500) no matter the strategy (in this case price-weighting instead of mkt cap weighting can be considered a strategy).<p>The reason it's cited so widely is that there's a lot of historical data on the Dow 30, whereas every other index is less reported.<p>[1] Yahoo Finance comparison of Dow 30 vs. S&P500 chart <a href="http://finance.yahoo.com/chart/%5EDJI#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%3D" rel="nofollow">http://finance.yahoo.com/chart/%5EDJI#eyJjb21wYXJpc29ucyI6Il...</a><p>[2] Dow 30 index is built and maintained by a subsidiary of News Corp. <a href="https://en.wikipedia.org/wiki/S%26P_Dow_Jones_Indices" rel="nofollow">https://en.wikipedia.org/wiki/S%26P_Dow_Jones_Indices</a>.<p>[3] <a href="http://www.etf.com/etf-education-center/21038-how-to-run-an-index-fund-full-replication-vs-optimization.html" rel="nofollow">http://www.etf.com/etf-education-center/21038-how-to-run-an-...</a><p>[4] <a href="http://www.investopedia.com/terms/w/washsalerule.asp" rel="nofollow">http://www.investopedia.com/terms/w/washsalerule.asp</a>
It is nice to see someone dig deeply into what the numbers actually mean, but it is surprising to see them come away with the wrong conclusions.<p>The DOW isn't useless, look at this graph : <a href="https://www.google.com/finance?chdnp=1&chfdeh=0&chdet=1491778123622&chddm=502044&cmpto=INDEXDJX:.DJI;INDEXSP:.INX;INDEXNASDAQ:.IXIC&cmptdms=0;0;0&q=INDEXDJX:.DJI,INDEXSP:.INX,INDEXNASDAQ:.IXIC&ntsp=0&ei=HbrqWMm9N8TxjAHv6bvIDg" rel="nofollow">https://www.google.com/finance?chdnp=1&chfdeh=0&chdet=149177...</a> which is a comparison of the DOW, S&P and NASDAQ indices. Note how closely the DOW and S&P 500 track each other? If the DOW was 'useless' as the author surmises, and the S&P 500 is 'better' then why are they so closely correlated?<p>The answer is of course that membership in the DOW (and S&P 500) changes over time. The selection of companies and their weighting is done by people who look at the impact a particular company has and how its stock price 'leads' or 'trails' the market. You pick 30 of those and they become your 'signal' for the health of the market.
S&P 500 and the Dow are highly correlated (95% over the past 50 years) and so as an overall temperature of the market it's typically sufficient.
Not sure how this got to the front page. This is not new information or even that interesting.<p>Literally, hundreds of articles about this exact same thing<p><a href="https://www.google.com/webhp?sourceid=chrome-instant&ion=1&espv=2&ie=UTF-8#q=dow+jones+price+weighted" rel="nofollow">https://www.google.com/webhp?sourceid=chrome-instant&ion=1&e...</a><p>another brand new site up-voted to the font page...created in 2017 and only 8 very sparse articles<p>erikrood.com