Journal of Financial Planning: October 2021
David M. Cordell, Ph.D., CFA, CFP®, CLU, is director of finance programs at The University of Texas at Dallas.
I admit that the title above is a shameless attempt to grab your attention. I lifted it from the James Bond movie You Only Live Twice in which Ernst Stavro Blofeld shouted, “Kill Bond! Now!”
If your name happens to be Dow Jones, I mean no offense. I wish for you a long and prosperous life. Nor do I wish to sully the names of Charles Dow or Edward Jones, who were founders of the company that bears their surnames. It’s the Dow Jones Industrial Average (DJIA) that I would like to kill. Although that will never happen, let me share a few reasons why financial planners should forget the DJIA.
The Concept Is Ill-Conceived
What is the underlying concept of the DJIA? The word is in the title: average. Average what? It relates to the average stock price of the 30 stocks in the DJIA. That is, add all 30 stock prices and divide by a divisor. Why should anyone care about the average price of a group of stocks? Well, I suppose that changes in the average price of a set of prominent companies could give a general idea of movements in the market, but it is worse than an imperfect measure.
Consider what happens if one started a market performance measure based on an average price that included 30 companies. (DJIA actually started with 12.) What happens if one of the stocks has a four-for-one split, for example? Well, that stock’s total market value would be unchanged, but its number of shares would increase by a factor of four, and its price would be divided by four. If none of the other 30 prices were to change, the lower stock price would decrease the sum of the 30 stock prices, so the average would decline. A decline in the average, however, doesn’t make sense since total wealth would not have changed.
The good news is that the divisor is adjusted anytime there is a stock split or stock (not cash) dividend. Because of all the splits and stock dividends among the DJIA companies over the years, the divisor on July 22, 2021, was—wait for it—0.15188516925198. No, that’s not a joke. You can find the current divisor every day in The Wall Street Journal, just above the graph of the DJIA’s recent performance.
The bad news is that the stock that just had a four-for-one split, presumably because it had performed well, just became less important in the average. Here’s why. Let’s say that the original price of XYZ Corporation was $100 before the split, which means the split would cause the price to adjust downward to $25. Before the split, a 10 percent increase in XYZ’s price would have increased the sum of the 30 stock prices by $10. After the split, a 10 percent increase in XYZ’s price would increase the sum by only $2.50. Put another way, that well-performing XYZ stock lost much of its influence in the average since its future price movements are likely to be only one-fourth what they would have been without the split. The good performers become underweighted in the average precisely because they performed well.
This approach to market indicator construction is called price weighting, thus the DJIA is a price-weighted market indicator. The higher the share price of a particular stock, the more impact it has on the market indicator. The Standard & Poor’s (S&P) 500 and most other market performance indicators are market-value weighted. A company’s influence on a market-value-weighted indicator is based on the total market value of the company, which of course considers not only the price but also the number of shares. Big companies are more important than small companies.
Does it matter? Consider this: Apple is one of 30 stocks in the price-weighted DJIA, or 3.33 percent of the total number of stocks. Because of the price reductions caused by its stock splits, Apple’s price represents only about 2.6 percent of the sum of the prices of all 30 stocks, which ranks it only about 22nd among the 30 stocks in terms of its importance in the DJIA. In terms of market value, though, Apple is the largest company and represents about 22 percent of the total market value of all the 30 stocks. By comparison, Goldman Sachs’s market capitalization is only about 5 percent as large as Apple’s, but Goldman is 2.5 times as important in the DJIA because of its high price. Does this make sense?
Have you seen the movie The Princess Bride? The character Vizzini, played by Wallace Shawn, has a penchant for remarking “inconceivable.” After hearing it multiple times, Inigo Montoya, played by Mandy Patinkin, finally responds, “You keep saying that. I don’t think it means what you think it means.” (Be patient. I’m going somewhere with this!)
Some market watchers might argue that the DJIA and the S&P 500 are fairly highly correlated, so it really doesn’t matter much which indicator you use to evaluate portfolio performance. Well, I’m not saying that correlation doesn’t mean what you think it means, but it’s inconceivable that high correlation fully reflects the relative performance of two market indicators. Here’s an example of how correlation can misrepresent the relationship.
Most people think of high correlation as meaning that two series of numbers move in lockstep over time. That is partially true, but it depends on your definition of lockstep.
Check out the two imaginary stock market indicators in the table and graph above. It is easy to see from the graph that Market Indicator B is much more volatile than Market Indicator A. Recalling that the correlation coefficient ranges from -1.0 (perfect negative correlation) to 1.0 (perfect positive correlation), what do you suppose the correlation coefficient is between A and B? Well, it’s actually 1.0—perfect positive correlation. You can check it out yourself in Excel or with many financial calculators.
Looking more closely, Market Indicator B has a 12 percent average return compared to only 8 percent for Market Indicator A. Market Indicator B is also far more variable with a standard deviation that is three times larger than that of Market Indicator A. In spite of their high correlation, these two market indicators are quite different from one another. By extension, paying attention to the DJIA is folly if your logical benchmark is the S&P 500.
Nobody Invests in the DJIA
The list of the 10 largest mutual funds and exchange-traded funds is dominated by index funds based on either the S&P 500 or the so-called total market portfolio. If the benchmark is the S&P 500, and it usually is, one can buy shares of an S&P 500 index fund, knowing that its performance will track the index, although slightly lower because of expenses. It is a once-and-done process—no additional buying or selling is necessary to balance the portfolio because the S&P 500 index fund and the actual S&P 500 index adjust to price changes identically.
Does anyone try to index with respect to the DJIA? No. In fact, ask yourself if any sane person would allocate their stock investments proportionately according to each individual stock’s respective market price. Consider what would happen when there is a stock split or stock dividend. You would have to reduce your allocation to that stock because it would have declined as a percentage of the sum of the 30 stock prices. In other words, you would have to sell some of that well-performing stock and invest the proceeds among the other 29 stocks.
So Kill It Already!
Those aren’t the only problems with the DJIA. For example, the stocks in the DJIA are all mega companies—so large that most people have heard of at least two-thirds of them. They are not representative of the market as a whole. Further, the companies in the DJIA don’t represent industrial sectors of the market proportionately. For example, there are no airlines or other transportation companies. Instead, there is the Dow Jones Transportation Average, which has the same problems mentioned above, and which no one pays attention to.
As I mentioned in the opening paragraph, I lifted the title of this article from a James Bond movie. Fortunately, Blofeld’s command to kill Bond wasn’t successfully accomplished. It is “inconceivable” that the owners of the James Bond franchise would kill Bond. Unfortunately, I’m afraid that killing the DJIA has about the same chance of success.
Consider that the DJIA is owned by the Dow Jones Company, which is owned by News Corporation. Among the companies under that umbrella are The Wall Street Journal, Barron’s, Fox Business Channel, and MarketWatch. In addition, almost every newspaper, radio station, and television station reports the Dow Jones Industrial Average every day. Would you kill something that caused every news outlet in the country to repeat your company’s name multiple times daily?