Why the Dow Jones is a flawed index

Ever since the U.S. presidential election there has been a large divergence in returns between the S&P 500 and Dow Jones Industrial Average (DJIA). Year-to-date, the DJIA is up 4.60% and the S&P 500 is up 5.41%. The financial media and nightly news have always placed more of an emphasis on reporting the daily moves of the DJIA. As large milestones such as Dow 20,000 are crossed, there is always a discussion around key market levels. This is meaningless information for long-term investors.

In my 15 year career working at large financial institutions, I never had one client track their return against the DJIA index. The reason is that large institutions understand that the construction of this index is flawed. The DJIA is a price-weighted average of 30 large-cap U.S. companies. These companies tend to be the oldest and most popular businesses and represent a very good barometer of the overall health of the economy. The flaw of the DJIA index is that the large priced stocks have a much larger influence on the return.

For example, Goldman Sachs, is one of the highest-priced stocks, trading around $217. This one company accounts for around 9% of the total index. On the flip side, General Electric, is one of the lowest priced stocks, trading at around $30. The weighing of GE is equal to approximately only 1% for the DJIA. A move in Goldman Sachs has 9X the influence on the change of the price compared to General Electric.

This week a few of the larger priced DJIA stocks missed earnings – IBM, JNJ, Travelers, and Goldman Sachs saw a significant drop in price. The combined total drop in price was around $22 for these companies.  This change in price is equivalent to GE nearly going out of business this week!

A better proxy for market returns is the Standard & Poor’s 500 (S&P 500). This index is a market value-weighted index of 500 stocks. The components of these companies are by the actual size of the company in the market. The S&P 500 also attempts to mirror the diversity of the largest companies. As companies grow is size, they will become a larger component of the S&P 500 index.

The high returns over the last few years of the S&P 500 index has helped to propel the popularity of investing in the exchange-traded S&P 500 index (SPY). Most active mutual fund managers have not kept pace with returns against this index. However, there are more active managers that have done a better job at managing risk to this benchmark. It’s the risk-adjusted return that should matter most to investors. The risk of the S&P 500 is largely misunderstood by the public. There is now a much higher weighting of technology companies in the S&P 500. In 2009, technology companies only represented a 15% weighting in the index compared to approximately 21% in 2017.

This larger weighting is a major reason why I believe that the volatility for the S&P 500 will be higher in the future. Over the next month, I expect market moves to increase as major technology companies such as Apple, Amazon, Facebook, Microsoft, and Google report earnings. Positive earnings reports and future revenue guidance from these companies is much more important than the political games being played out in Washington.

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