Why The Dow? The Problem With Price WeightingSubmitted by Concorde Financial Resources LLC on September 10th, 2018
“What did the market do today?” That’s a fairly common expression or question thrown around. The “market”. What exactly does that mean? I can tell you that the common assumption for this question is that most people are referring to the Dow Jones Industrial Average, or simply ‘the Dow’. The Dow began in 1896 and originally consisted of only 12 Industrial stocks. Today the Dow is made up of 30 large companies. JP Morgan (JPM), Wal-Mart (WMT), Apple (AAPL), Exxon Mobil (XOM) and Coca-Cola (KO) just to name a few. Is 30 companies enough of a measure for this broad question? And do we put too much emphasis on this index in a new, 21st century economy?
To understand how the Dow works, you must understand it is a price-weighted index. Simply put, that means a more expensive stock price gets more of a weighting in determining the Dow’s price. Let’s see below for a quick illustration.
|Stock A||Stock B||Stock C|
|Initial Market Cap||$300B||$3B||$300MM|
|New market cap||$296.4B||$3.024B||$330MM|
|Change in market cap||($3.6)B||$24MM||$30MM|
Of course, you could just look at the top line and think Stock C is the most expensive stock. And in the Dow, it would have the highest weighting (therefore have the most impact on the index), however if you look at who is the biggest company, it is Stock A (the cheapest stock) by far! In this example, A moves -1.2% and C moves 10% in one day. The move in Stock A is a much more profound movement, although the Dow would consider Stock C as a much more important weighting. Immediately you can see the problematic nature of a price weighted index. Just because the price of one share of stock is higher than another, does not make it a more expensive or larger company than a much lower priced security.
Another reason I don’t like saying the Dow is “the market” benchmark is because of our economy’s growing dependence on technology. The NASDAQ, and technology as a whole, is where much of the world’s growth is currently happening. Our lives are constantly being shaped by technology. Food supplies, work environments, banking, even automobiles and energy, you name it. All of the “normal” industries are now being severely disrupted by technology and therefore technology is where the majority of the growth is taking place in the 21st century. Should the NASDAQ be “the market” we reference? Perhaps not yet, but increasingly the answer is drifting towards yes. And if you want an easier benchmark for “the market”, why not just consider the S&P 500? This index has 500 large companies from all industries and seems to be a better gauge due to its breadth of exposure to many more sectors and industries. The S&P 500 is cap weighted, meaning the bigger companies, not the more expensive stocks, have a heavier weighting. That makes more sense to me. Apple is now a $1 trillion dollar company (recent event). It’s logical that it should move the index more than say Chipotle (CMG), even though Chipotle has a stock price more than double that of Apple. This highlights the irrelevancy of a stock’s price and the importance of cap weighting when comparing stocks.
As with any subjective question, the answer comes with a good deal of nuance. Just remember the next time you ask someone “how’s the market doing?” that you could be talking about two entirely different things….
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