Why the Dow Is a Dumb Index

The Dow Jones industrial average is hopelessly archaic. When it was created in 1896 with just 12 stocks, its chief selling point was that it could be quickly calculated using only pencil and paper. Today, the Dow consists of 30 large companies, chosen by editors of the Wall Street Journal.

The small number of stocks is one shortcoming. By contrast, other important benchmarks of the U.S. stock market contain 500 stocks (Standard & Poor's 500-stock index), 1,000 stocks (Russell 1000) and about 5,000 (Wilshire 5000).

Moreover, Journal editors tend to add companies after they've passed their prime, giving rise to the argument that entering the Dow is more curse than blessing. Over the past ten years, new Dow stocks lost an average of 20% in the first year after their inclusion. Microsoft is 38% below its level when it was added in late 1999. American International Group, which entered in 2004, is already out of the Dow. Bank of America is off 58% since joining in early 2008.

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The Dow's biggest fault is that it weights stocks according to share price rather than market capitalization. As a result, a 1% move in the price of IBM, which closed at about $120 in mid August, counts about six times as much in the Dow as a 1% change in Intel, which closed at $19, even though IBM's market value is only 51% greater than Intel's.

Gus Sauter, chief investment officer at the Vanguard Group, says 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 500 or a total-market index." Perhaps the Dow's biggest accomplishment is that, warts and all, it has retained its status as the public face of the U.S. market.

See What Now for the Dow