The Dow, IBM, and Benchmarking

The Dow Jones Industrial Average (DJIA) is a bizarrely calculated index . If most people understood how it was calculated, they wouldn’t follow it anymore.

Yesterday happened to be one of those days when the Dow was down (-0.01%) but the S&P 500 was up (+0.67%). This was primarily due to two stocks in the Dow, IBM and Goldman Sachs, which were down a lot, -6.37% for IBM and -2.42% for Goldman Sachs.

Why would the drop in these stocks effect the Dow more than the S&P 500? It has to do with how the Dow is calculated, which provides a great lesson on benchmarking.

Only 30 stocks

First, there are 30 stocks in the Dow and 500 in the S&P 500. Just based on that, the S&P 500 provides a better idea of the true market averages. With only 30 stocks in the Dow, it is more effected by each individual stock than is the S&P 500.

It gets weirder

There is a much more bizarre aspect to the Dow Jones. It is a “price weighted” index. This means that the price-per-share determines the impact that a stock will have on the index. If a stock is $100 per share, its movement will effect the index twice as much as a stock that is $50 per share.

At $174.83 per share, IBM has a much larger impact on the Dow than Microsoft, which is at $34.92 per share, despite the fact that Microsoft is a larger company by about $100 billion.

What the heck??

Once you understand this, a typical reaction is – what the heck!!! Why is it done this way?

The answer is in history and tradition. The Dow is one of the oldest indexes. Long before calculators and computers, investors wanted a quick way to get an idea of how the market did on a given day. The easiest way was to add up the price of all the shares in the index and divide to get an average. The natural problem with this technique was that simply having a higher share price meant a stock had a larger impact on the average.

So it makes sense why the Dow Jones is calculated this way. I actually think it’s cool to trace the index back to its origin in history. But if you are benchmarking your performance to the Dow, keep in mind that your benchmark is an archaically calculated index that may have little to do with the holdings in your portfolio.

 

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