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The Dow - The Most Popular and Most Flawed Index in the World?
By, Simon Maierhofer
Wednesday July 11, 2012
Trick question: Is the Dow Jones Industrial Average (tracked by the Dow Diamonds ETF - DIA) the most widely recognized stock market index in the world? No, technically it isn't. Here's why and what makes the Dow the most flawed "index" on Wall Street.

If you’ve ever come across the word “charming” in a for rent or for sale listing, you probably know it’s code for “unique in an old and antiquated kind of way.”

You know what else is charming? The Dow Jones Industrial Average (DJI: ^DJI). The Dow is the dinosaur among market indexes in more ways than just longevity.

Unlike other market cap weighted indexes like the S&P 500 (SNP: ^GSPC), Russell 1000 (Chicago Options: ^RUT) and Nasdaq (Nasdaq: QQQ), the Dow (NYSEArca: DIA) is price weighted. It should therefore be considered an average not an index.

Old World Charm Meets Wall Street

The value of the DJIA could literally be calculated with just pen and paper by adding up the share prices of its components and multiplying the sum by 7.58 (or dividing the sum by 0.132). 7.58 (or 0.132) is the divisor used to keep the DJIA value constant.

Component stocks being price weighted means that the company with the highest stock price is the VIP. With a price tag of 191 that’s IBM (NYSE: IBM). In fact, IBM is priced so much higher than its fellow Dow component stocks that it dominates the Dow’s performance with an 11.5% weighting.

To illustrate, let’s compare IBM with the Dow’s smallest component – Bank of America (BAC).

Earlier this year BAC gained as much at 81%. This impressive gain added a whole 35 points to the Dow’s performance. The same gain in IBM would have propelled the Dow by 1,130 points.

Price Weighted vs. Market Cap Weighted

The deeper you dig the more intriguing the Dow’s weighting structure becomes. Here are a few more factoids:

The top five price weighted DJIA stocks account for about 34% of the index, while the bottom five have a combined 5% weighting. The same top five stocks account for only 18% of the market cap while the bottom five account for 11%.

IBM has about 10 times the weighting of GE but only about 25% more market capitalization.

The chart below makes it easy to dig up more anomalies (if you so choose). The chart shows the Dow’s components sorted by their price weighting (blue columns) contrasted by their market cap weight (dotted black column).

Know Thy Index (or Average)

The Dow’s performance is pretty much in line with that of the S&P or Russell 1000, so what’s the fuss about the Dow’s anomalies?

Investors should be aware of any one stock dominating an index they own. IBM makes up 11.5% of the Dow and Apple accounts for 20% of the Nasdaq-100. If you own any of those lopsided indexes you should watch its key components more than just peripherally.

There will be a time when a major component will provide a strong buy or sell signal and odds are the index will move in the same direction as its alpha male.

If your goal is to assemble a balanced portfolio, there’s no need to own the Dow Diamonds (NYSEArca: DIA) and IBM shares, or the Nasdaq  and Apple shares.

And even if any of the above information doesn’t affect you or your style of investing/trading at all, you’ve just learned something that probably fewer than 1 out of 10 investors know.

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