Whenever anybody asks how the market did on a given day, chances are good they will tell you how the Dow Jones Industrial Average performed. Back in the early 20th century, this was the market barometer, consisting of the major industrial powers of the country. Those days are long gone and relying on the Dow will not give you an accurate reading on the market’s health. Here are a few problems with the Dow and some good alternatives.
Only 30
The first big problem with following the Dow is that it only contains 30 stocks. With a market full of 10,000 stocks, that obviously isn’t a great cross section of the market. It is very possible that the Dow could be up or down significantly and the other averages sing to a totally different tune altogether. For example, the Dow outperformed the S&P 500 and NASDAQ by a large margin on Tuesday.
Also, the index is solely comprised of large cap stocks. Alcoa (AA) is the smallest company in the index with a market cap around $16 billion, and the next smallest is Dupont (DD), coming in around $45 billion. Ideally for an index to be considered a market barometer, it should be comprised of all sizes.
My biggest problem with the Dow is the fact that it is price-weighted. This means that a higher share priced stock will have more influence than a lower one. We all know that the share price itself is meaningless since a company can decide to split or reverse split its stock at anytime. For example, $5 stock like Citigroup (C) would be almost inconsequential whereas a $340 like Apple (AAPL) would exert tremendous influence on the average. (Neither are in the Dow)
Alternatives
The S&P 500 is the main benchmark that money managers use, but even that is too skewed towards large caps for my liking. I prefer the Wilshire 5000 or the Russell 3000 indices. These comprise most of the stocks in the market and should be used as the measure for how the market did on a given day. Next time somebody asks you how the market did, don’t make the mistake of quoting the Dow Jones.
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