The DJIA's Dangerous Indexing Philosophy

While doing some research on the Dow Jones Industrial Average, I was disappointed to discover how skewed it is toward just a few of its components and how dangerous it is for the world to use it as a benchmark for the American markets. The DJIA is a price weighted index, which simply means that the weighting of the index is based on the price of each component. By price I do not mean Market Capitalization but I mean the actual price it is trading at. Please look at the table below to see what I mean:

Dow Jones Industrial Average Components
STOCK	% WEIGHTING	PRICE
IBM	9.31	$120.56
Chevron	5.92	$ 76.64
3M	5.73	$ 74.28
ExxonMobil	5.57	$ 72.15
United Technologies	4.84	$ 62.66
Johnson & Johnson	4.59	$ 59.49
McDonalds	4.57	$ 59.16
Procter & Gamble	4.55	$ 58.95
Caterpillar	4.28	$ 55.49
Coca-Cola	4.15	$ 53.72
Wal Mart	3.88	$ 50.28
Travelers	3.88	$ 50.20
Boeing	3.73	$ 48.27
Hewlett Packard	3.72	$ 48.16
JPMorgan Chase	3.29	$ 42.58
American Express	2.75	$ 35.68
Dupont	2.49	$ 32.27
Merck	2.41	$ 31.26
Verizon Communications	2.27	$ 29.41
Microsoft	2.15	$ 27.88
Kraft Foods	2.13	$ 27.64
Disney	2.12	$ 27.41
AT&T	1.98	$ 25.59
Home Depot	1.93	$ 25.06
Cisco Systems	1.78	$ 23.00
Intel	1.47	$ 19.01
Pfizer	1.31	$ 16.95
Bank of America	1.13	$ 14.63
General Electric	1.12	$ 14.47
Alcoa	0.96	$ 12.48

As you can see from the table above, the top 10 companies on the list represent 53.51% of the Index , so for example if all those 10 companies have a terrible day and the rest of the 20 have a decent day, the DJIA Index will still show a large loss.

Here is the same table but by Market Capitalization ($billions) instead;

Dow Jones Industrial Average Components
STOCK	MARKET CAP	% WEIGHTING
IBM	$159.16	4.90%
Chevron	$153.82	4.74%
3M	$52.43	1.61%
ExxonMobil	$340.55	10.49%
United Technologies	$59.25	1.82%
Johnson & Johnson	$162.40	5.00%
McDonalds	$62.65	1.93%
Procter & Gamble	$174.53	5.38%
Caterpillar	$35.17	1.08%
Coca-Cola	$122.92	3.79%
Wal Mart	$192.46	5.93%
Travelers	$27.36	0.84%
Boeing	$33.55	1.03%
Hewlett Packard	$112.65	3.47%
JPMorgan Chase	$168.18	5.18%
American Express	$42.85	1.32%
Dupont	$29.42	0.91%
Merck	$64.68	1.99%
Verizon Communications	$82.59	2.54%
Microsoft	$244.44	7.53%
Kraft Foods	$40.62	1.25%
Disney	$51.33	1.58%
AT&T	$149.65	4.61%
Home Depot	$42.61	1.31%
Cisco Systems	$132.63	4.08%
Intel	$102.43	3.15%
Pfizer	$113.99	3.51%
Bank of America	$128.02	3.94%
General Electric	$152.34	4.69%
Alcoa	$12.34	0.38%
TOTALS	$3,247.02	100.00%

As you can see the top ten stocks equal 40.75% (when judged by market cap) of the Index instead of the 53.51% that is used to actually measure it by price.

The real problem with the index is not the top 10 stocks but the bottom 11 instead, which when taken by price represent just 18.08% of the index, but when judged by market cap represent 36.03% of the total market cap of the Index.

Finally here are the two tables combined that will show you what a mess the DJIA Index is and why it is so dangerous for market participants to rely on it as their benchmark.

Dow Jones Industrial Average Components
STOCK	BY MARKET PRICE	BY MARKET CAPITALIZATION
IBM	9.31%	4.90%
Chevron	5.92%	4.74%
3M	5.73%	1.61%
ExxonMobil	5.57%	10.49%
United Technologies	4.84%	1.82%
Johnson & Johnson	4.59%	5.00%
McDonalds	4.57%	1.93%
Procter & Gamble	4.55%	5.38%
Caterpillar	4.28%	1.08%
Coca-Cola	4.15%	3.79%
Wal Mart	3.88%	5.93%
Travelers	3.88%	0.84%
Boeing	3.73%	1.03%
Hewlett Packard	3.72%	3.47%
JPMorgan Chase	3.29%	5.18%
American Express	2.75%	1.32%
Dupont	2.49%	0.91%
Merck	2.41%	1.99%
Verizon Communications	2.27%	2.54%
Microsoft	2.15%	7.53%
Kraft Foods	2.13%	1.25%
Disney	2.12%	1.58%
AT&T	1.98%	4.61%
Home Depot	1.93%	1.31%
Cisco Systems	1.78%	4.08%
Intel	1.47%	3.15%
Pfizer	1.31%	3.51%
Bank of America	1.13%	3.94%
General Electric	1.12%	4.69%
Alcoa	0.96%	0.38%

In conclusion, my opinion would be to stop using the Index until it is based on Market Capitalization instead of price.

In my own work I only use the NYSE Index and you can read why here: seekingalpha.com/article/168636-nyse-the...

Disclosure: Long MSFT, IBM, JNJ and MRK, with no position in the others.

The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of Peter “Mycroft” Psaras, and should not be construed as personalized investment advice.

It should not be assumed that investing in any securities we are investing in will always be profitable. We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.

Comments

[adcva:]

Duh. This has, of course, always been the case. Why the media insist on reporting the DJIA instead of any other index, in fact equating it to the entire stock market, is the mystery.

On a related note, one should look into the manipulation of Standard & Poor's of their most-visible index, the S&P 500. The frequency of "re-balancing" has increased dramatically over the past 15 years, and it you look at its composite P/E, you may start to get suspicious...

Nov 04 08:00 AM

[predictorma...:]

There is also a deriviative effrct on ETF's particularly leveraged ETF's. You're basing "investment" decisions on a nonreflective average. You can see it lately where the DJIA is frequently in the opposite direction of the overall market tone.

Nov 04 08:33 AM

[John Galt:]

It's like judging a pitcher in baseball based on "wins"...
or only looking at a guys batting average "and not walks"
or judging a quarterback only on his winning percentage

How some of these ways we measure things came about, I don't know, but there are better ways of doing things.

Nov 04 08:55 AM

[Cru Jones:]

It is what it is. Look at the bright side - IBM, trading at very modest multiple by historical standards, has 9 times the weight of troubled GE or Alcoa. I agree that their weightings are ridiculous - hell Google had no chance to join DJIA in the recent rebalancing b/c it would've been over 20% of the index - but in some ways the DJIA weightings are exactly why I like its prospects better than the S&P500. And looking at the correlation with the broader index, I wouldn't call the DJIA indexing methodology "dangerous." Dumb maybe, but not dangerous.

Nov 04 09:55 AM

[Edward, Lor...:]

no suggestion as to which is the cause and which the effect.

Nov 04 10:14 AM

[Graybeard44:]

So tell me, how is it better to have Exxon-Mobile with 10.5% of the index, rather than IBM with 9.5%? Or XON and CVX together with 15%, rather than IBM and INTC together with 10.5%?

Either system is out of balance, just with different winners and losers.

Nov 04 11:05 AM

[BigOlDave:]

I compare my portfolio with the S&P 500.

Maybe that's because, when I hear the media report "the S&P is up 1.09 points for the day, closing at 1046.50", it's easy for my aging mind to calculate that the market's moved only about a 10th of a percent.

So I'll assume that I've made a little money today.

Nov 04 05:33 PM

[Skjellifetti:]

The Fine Print: As Registered Investment Advisors ...

And you just now figured this out?

Nov 04 10:25 PM

[Dbrunt:]

I guess puting Google or Berkshire Hathaway into the Dow will be a touugh one to swallow.

Nov 04 11:13 PM