For many years, I have wondered why Dow Jones insists on retaining the antiquated price-weighted calculation for its most prominent index, the Dow Jones Industrial Average. Prior to the availability of computers, I can see why it would be attractive to use a price weighted index given that it is simpler to calculate compared to a market value weighted index such as the Standard & Poors 500. However, this makes no sense today and has not made sense for several decades. Why would Dow Jones retain such a flawed calculation methodology for decades after cheap and easy computing became widely available?
As many have noted in recent weeks, the price weighted nature of the DJIA has made it a highly misleading measure of broad stock market performance. This is because price weighted indexes give much more weight to stocks with higher prices per share. For example, a stock trading at $100/share has a higher impact than a stock trading at $10/share. The impact of the $100 stock rising ten percent to $110 is exactly the same as the impact of the $10 stock doubling in price to $20.
The flawed nature of the DJIA is highly evident today due to the collapse in the market value of key components. As the Wall Street Journal noted on Tuesday, February 24, there are now five stocks in the DJIA trading under $10 per share: Bank of America, Citigroup, General Motors, General Electric, and Alcoa. If all of these companies became worthless, the DJIA would only fall around 200 points but surely this dramatically understates the true impact of such an event.
In addition, the price weighted structure discourages Dow Jones from adding companies to the index that trade at relative high prices. Can anyone imagine what would happen if Berkshire Hathaway was added to the DJIA?
The solution is simple and obvious: Dow Jones should convert to a market value based measurement for the DJIA. In the absence of such a move, investors should disregard the DJIA’s movements and focus on market cap weighted indices such as the S&P 500. Clearly, most professional investors already look at the S&P 500 rather than the DJIA, but the DJIA retains its special place in American culture and is the most widely followed measure that the general public looks at to follow stock market performance.