Why Is the Dow Jones Industrial Average Considered Outdated?

The Dow Jones Industrial Average, often referred to as simply “The Dow” despite there being multiple stock market indices that bear the Dow Jones name or shorthanded as DJIA, remains one of the most well-known proxies of the broader stock market in the United States. In fact, if you were to approach a random person on the street, the odds are much better they could give you a rough idea of the current level of the Dow Jones Industrial Average than they could estimate the level of the S&P 500 despite the latter having exponentially more assets invested in index funds that mimic the methodology.

Why, then, is the Dow Jones Industrial Average still so popular? What makes the DJIA outdated? These are great questions and, in the next few minutes, I want to take the time to give you a bit of history that can provide a more robust understanding of this anachronism came to dominate not only the financial press but the broader public’s mind when it came to common stocks.

First, let’s review what you already know about the Dow

The DJIA, among other things...

• The value of the DJIA is calculated using a formula based on the nominal share price of its components rather than another metric such as market capitalization or enterprise value;
• The editors of The Wall Street Journal decide which companies are included in the Dow Jones Industrial Average.
• Some myths about the historical performance of the stock market index, if it weren’t for a mathematical error that occurred early in the history of the Dow that understated performance, the DJIA would presently be at 30,000, not the 20,000 record it recently shattered. Likewise, if the editors of The Wall Street Journal had not decided to remove International Business Machines (IBM) from the index components only to add it back in years and years later, the Dow Jones Industrial Average would be roughly twice its current value. Yet another example is the oft-repeated myth, usually tied to people talking about survivorship bias without understanding the specifics of that phenomenon, that a large majority of the original components of the Dow Jones Industrial Average ended up failing, which is anything but the truth. Through mergers and acquisitions, a buy and hold investor who acquired the original Dow and sat on his or her behind experienced perfectly satisfactory returns on an aggregate basis and ended up with a perfectly fine portfolio. 

Interestingly, despite its significant flaws, over the long-term, the Dow Jones Industrial Average has had an interesting habit of beating the S&P 500 which is theoretically better designed despite what some consider to be its own significant methodological flaws as presently constructed.

Let’s examine the short-comings of the Dow on a case-by-case basis

To better understand the criticisms of the Dow Jones Industrial Average, it can be to our benefit to walk through them individually.

Criticism 1: The Dow Jones Industrial Average’s emphasis on nominal share price rather than market capitalization or enterprise value means it is fundamentally irrational as it can result in components having weightings that are wildly disproportionate to their overall economic size relative to each other.

Frankly, there’s not much defending this one as the idea an index’s valuation should be determined by nominal stock price, which can be changed through economically meaningless stock splits, is pretty much indefensible. The good news is that, historically, it hasn’t made too much of a difference in practical terms though there is no guarantee the future will repeat itself as it has in the past.

One way an investor could overcome this would be to build a directly held portfolio that contained all of the companies in the Dow Jones Industrial Average, weight them equally, and then have the dividends reinvested according to some set methodology; e.g., reinvested into the component that distributed the dividend itself or reinvested proportionately among all components. There is considerable academic evidence that could lead one to conclude a portfolio constructed with this modified methodology might perform substantially better than the illogical share-price-weighted methodology currently employed though, even if that turned out not to be the case, the more equal distribution of risk would itself be an added benefit that could justify such a modification.

Criticism 2: The Dow Jones Industrial Average components, while significant in terms of market capitalization, exclude most the domestic equity market capitalization making it a less-than-ideal proxy for the actual experience of investors who own a broad collection of common stocks across multiple market capitalization categories.

It’s theoretically possible for the Dow Jones Industrial Average to experience a large rise or decline while a substantial majority of the domestic publicly listed equities in the United States go in the opposite direction. This means the headline number printed in newspapers and featured on the nightly news doesn’t necessarily represent the economic experience of the typical common stock investor.

Again, this is one of those areas where, while true, the question an investor has to ask himself or herself is, “How much does this matter?”. The Dow Jones Industrial Average has serviced as a historically “good enough” proxy that roughly approximates the general condition of a representative list of the biggest, most successful businesses across multiple industries in the United States. Why is it necessary for it to somehow encapsulate the aggregate domestic equity market? To what end would that serve anyone considering that the investor can open his or her brokerage statement and see how well he or she is doing.

Criticism 3: The Editors of The Wall Street Journal are effectively able to overweight qualitative factors when determining which companies to add or delete from the Dow Jones Industrial Average. This introduces the problem of human judgment.

Humans are not perfect. Humans make mistakes. As previously mentioned, many decades ago, the editors of The Wall Street Journal made the ill-fated decision to remove International Business Machines, or IBM, from its list of components. IBM went on to crush the broader stock market index and was later reintroduced during a subsequent update to the component list. Had IBM never been removed in the first place, the DJIA would be approximately twice as high as it currently is.

Here, again, the problem is largely not as significant as I think a lot of people seem to think and, in many ways, is superior to quantitatively-driven models which are not, really, so logical once you figure out what is moving them. Consider a Dow Jones Industrial Average in an alternate universe; a stock market index of the largest 30 stocks in the country that are weighted by market capitalization. In this case, during periods of significant irrationality — think the 1990s stock market bubble — individual investors would effectively be acting as the editors of The Wall Street Journal are now only, instead of reasoned, rational financial journalists sitting at a conference table, the collective animal spirits of groupthink would be driving which companies got added or deleted in any given update.

Criticism 4: Due to the fact it contains only 30 companies, the Dow Jones Industrial Average is not as diversified as some other stock market indices are.

This is a criticism that is both mathematically dubious and simultaneously not as bad as it sounds given that the overlap between the S&P 500, which is weighted by market capitalization, and the Dow Jones Industrial Average is meaningful. Yes, the S&P 500 is better diversified but not nearly so much that it’s resulted in objectively superior performance or risk reduction over the past few generations; another mystery of the Dow’s performance. Besides, the Dow Jones Industrial Average isn’t meant to capture the performance of all stocks, it is intended to be a barometer; a rough estimate of what is generally going on in the market based on the leading companies that represent American industry.

Nevertheless, the premise of this criticism is an important one. Roughly 50 years’ worth of academic research sought to discover the ideal number of components in an equity portfolio to reach a point at which further diversification had limited utility.

The short version is that throughout much of history, the number of ideal components in a portfolio was thought to be somewhere between 10 stocks (see Evans and Archer back in 1968) and 50 stocks (see Campbell, Lettau, Malkiel, and Xu in 2001). It is just recently that the idea more stocks are necessary has begun to take hold (see Domian, Louton, and Racine in 2006) and only, then, if you accept the idea that increases in short-term volatility are meaningful to long-term investors who pay cash for their holdings and have no need to sell on any given timeframe.

To provide a counter-example to that last sentence, billionaire investor Charlie Munger, who is fond of holding securities outright with no debt against them and sitting on them for periods of 25 years or longer, argues that if a wise, experienced businessman or businesswoman knows what he or she is doing, and has financial experience necessary to understand and analyze risk, he or she would be justified holding as few as three stocks if those stocks were in incredible non-correlated businesses and not held in a hypothecated account.

For example, Munger sometimes uses an enterprise such as The Coca-Cola Company to illustrate his point. Coke has a market share so impressive that it generates cash from somewhere around 3.5 percent of all beverages humans ingest on the planet in any given day, including tap water, does business in 180+ functional currencies, enjoys mouthwatering returns on capital, and even boasts far more product line diversification than most people realize; e.g., Coca-Cola is not just a soda company, it is also a major provider of tea and orange juice, as well as has growing lines in other areas such as coffee and milk.

Munger argues that a company such as Coke might be an appropriate choice if — and this is a big if — the hypothetical expert investor with an enormous amount of experience and a substantial personal net worth far beyond what it would ever take to support himself or herself could devote the time necessary to remain involved and active in studying the firm’s performance with each quarterly release, treating it, in a sense, as if it was a privately held family business. In fact, he has supported this argument by pointing out that most — not all, but most — significant foundations that were backed by a large donation of founder’s stock would have done better over time to hold on to the initial stake rather than diversifying that stake through the sale of securities.

The crux of Munger’s argument comes down to the fact that he believes it is possible to reduce risk, which he does not define as volatility but, rather, the probability of permanent loss of capital, by understanding the actual operating risks of the companies one owns, which can be impossible if trying to keep track of something like 500 separate businesses.  

Some closing thoughts about the Dow Jones Industrial Average

We don’t have nearly as big a problem with the Dow Jones Industrial Average as a lot of people seem to because we take it for what it is — a useful, albeit limited, gauge of how things are going for major blue chip stocks in the United States. While it only has a fraction of the total assets tied to it as an indexing strategy, the S&P 500 has problems of its own.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.