The Dow Is an Outdated Index

The Dow Jones industrial average has finally gotten around to dumping two broken-down stocks, Citigroup and General Motors. Replacing them on June 8 were Cisco Systems and Travelers. Investors would have been better served if Dow Jones simply shut down its well-known but really dumb index.

The Dow is hopelessly archaic. When it was created in 1896, its chief selling point was that it could be quickly calculated using only pencil and paper. It consists of 30 large companies, weighted on the basis of their stock prices.

The following benchmarks provide more-accurate pictures of the U.S. stock market, and all are tracked by low-cost index funds:

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• Standard & Poor's 500-stock index tracks 500 mostly large companies. Stocks are weighted by their market capitalization, or value. You can invest in the S&P 500 through mutual funds from a variety of sponsors, including Fidelity, Schwab and Vanguard. Or, you can buy iShares Standard & Poor's 500-stock index (symbol IVV), an exchange-traded fund with a minuscule annual expense ratio of 0.09%.
• The MSCI U.S. Broad Market index includes nearly all publicly traded domestic stocks. Vanguard Total Stock Market ETF (VTI), which tracks the index, has annual fees of just 0.07%. If you'd prefer a regular mutual fund, Vanguard Total Stock Market Index (VTSMX) invests identically, charging 0.16% annually.
• The Russell 3000 index follows the 3,000 biggest U.S companies. You can buy this index through iSharesRussell 3000 Index (IWV), an ETF that charges 0.21% annually.

The Dow industrial's biggest flaw is its reliance on price-weighting to determine moves in the average. Price-weighting makes no sense. A 1% move in the price of IBM, which closed at $108.14 on June 9, counts for nearly seven times as much in the Dow as a 1% price change in Intel, which closed at $16.42, even though IBM's market capitalization of $143 billion is only 55% greater than Intel's market value of $92 billion.

The share price of a stock generally tells you nothing about the value of the company that issued it. For example, when a stock's price rises a lot, a company often implements a stock split, which lowers the share price but in no other way changes the company's value. Yet the mere act of splitting the share price of a Dow stock lessens the stock's impact on the average.

The more sensible way to construct an index -- and the one employed with all the other major stock indexes -- is to weight each stock based on its market capitalization. Market value is calculated by multiplying the share price times the number of shares outstanding.

Take, for example, the S&P 500-the most widely used large-company-stock index. ExxonMobil, with a market value of $357 billion at the June 9 close, accounts for 4.8% of the index. McDonald's, which has a market value of $65 billion, makes up 0.9% of the index. The New York Times Co., the smallest company in the S&P 500 as of June 9, has a market cap of $904 million.

Not surprisingly, the price-weighted Dow index has some problems compared with the S&P. Gus Sauter, chief investment officer at Vanguard, reports that the post-June 8 Dow underweights health care by five percentage points, utilities (of which it has none) by four points and financials by three points. The Dow overweights industrial stocks by eight points and consumer staples by 3.5 points.

Adds Sauter: "Nothing justifies weighting stocks by their prices. Fund managers don't pay attention to the Dow. If you're trying to get a handle on what the market is doing, you'll look at the S&P or a total-market index. I've never seen an institutional presentation where the Dow was used."

Why is it so popular, then? Historian Daniel Boorstin wrote, "The celebrity is a person who is known for his well-knownness." The Dow is a celebrity index. It's been around a long time, and it still gets a lot of publicity.

And the Dow's not the only celebrity index. The Nasdaq Composite index is just about as silly. It consists of stocks that trade on Nasdaq, but what does it tell you? Many Nasdaq stocks are technology stocks, but hardly all of them. "It's merely a listing venue," Sauter says. "We'd never use it for anything."

Want an index that reflects what the stock market does? Consider the Wilshire 5000, the Russell 3000 or the MSCI Broad Market index, each of which offers a good approximation of the entire U.S. stock market. For large companies, the S&P isn't bad. For small companies, use the Russell 2000, the S&P SmallCap 600 or the MSCI U.S. Small Cap 1750.

But don't hold your breath waiting for the Dow Jones industrials to disappear. Dow Jones, the News Corp. subsidiary that publishes the Wall Street Journal and the various Dow Jones averages, plainly has a vested interest in keeping the Dow industrials in the limelight.

Steven T. Goldberg (bio) is an investment adviser.