You have probably heard a lot lately about the Dow Jones Industrial Average approaching 20,000. And by the time you read this post, it may or may not have hit that historic mark. But it doesn’t really matter either way because the Dow is a terrible indicator, and here’s why:
There are 4,000 stocks traded on the New York Stock Exchange and NASDAQ every day, and the Dow tells us what just thirty of them are doing. That’s less than 1%. Plus, the thirty companies it does represent are mostly older companies like General Electric, Johnson & Johnson, and Exxon Mobil. It does not contain some of the more relevant companies like Alphabet (formerly Google) or Facebook.
The Dow is an average of stock prices, which may have been sophisticated back in 1896 when the Dow originated, but stock price only tells half the story—the other half is how many shares of the company are outstanding. The product of those two numbers, share price and number of shares outstanding, is the company’s market capitalization, and that is a much better indicator of a company’s worth.
For example, take two different companies with the same market capitalization of $100, but Company A has 100 shares outstanding valued at $1 while Company B has just 2 shares outstanding at $50. Now, say both companies increase in value by 10%, so they’re both worth $110. Company A’s stock will increase just $0.10 per share while Company B’s stock will jump $5 per share.
So even though both companies have experienced the same growth, Company B’s stock would have 50 times the effect of Company A’s on the Dow because it only looks at share price and doesn’t account for market capitalization. As a result, there are distortions in the Dow’s movement. In fact, 24% of the Dow’s 1,600 point rally at the end of 2016 can be contributed to one company—Goldman Sachs, the most expensive stock in the index.
If the Dow Jones Industrial Average is such a terrible metric, why is it quoted so often? Name recognition. People have heard of it because it’s been around the longest, so the financial media keeps reporting it. You should not track daily movements of your investments anyway, but if you feel the need, use the S&P 500 or Russell 3000. They are a much more accurate benchmarks for the overall US stock market.
Josh Norris is an Investment Advisory Representative of LeFleur Financial. Josh can be reached at josh@LeFleurFinancial.com.