Adam Davidson has a great article in TheNew York Times on the flaws of the Dow Jones Industrial Average (INDEX: ^DJI) . The index of 30 blue chip stocks most of us pay attention to as the symbol of the broader stock market is, as Davidson explains, badly misunderstood, and its results easily abused.
More troubling is that [the Dow] ignores the overall size of companies and pays attention to only their share prices. This causes all sorts of oddities. ExxonMobil, for example, divides its value into nearly five billion lower-cost shares, while Caterpillar has around 650 million more expensive ones. Therefore ExxonMobil, one of the largest companies in history, pulls less weight on the Dow than a company less than a fifth its size.
The Dow, in other words, is weighted by nominal share price, not market value. And the oddities Davidson describes are not one-offs; have a look at the most recent Dow weightings:
Current Weighting in Dow Index
Johnson & Johnson
Procter & Gamble
Bank of America
Some of these are astounding. Bank of America (NYS: BAC) has a higher market capitalization than Caterpillar (NYS: CAT) , yet Caterpillar commands nearly 15 times as much weight in the Dow. General Electric's (NYS: GE) market cap is just 9% less than IBM's (NYS: IBM) , yet it gets one-tenth the weighting.
How does this make sense? It really doesn't. The Dow may be the most popular, but other indexes such as the S&P 500 or the Wilshire 5000 give a much more accurate and reliable representation of the stock market -- and even they have their flaws.
At the time thisarticle was published Fool contributor Morgan Housel owns shares of Chevron, Microsoft, Intel, Wal-Mart, Exxon, B of A preferred, Johnson & Johnson, Procter & Gamble, Verizon, and AT&T. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Cisco Systems, Intel, Bank of America, Wal-Mart Stores, JPMorgan Chase, Microsoft, Johnson & Johnson, and Coca-Cola. Motley Fool newsletter services have recommended buying shares of The Home Depot, Pfizer, Cisco Systems, Intel, Visa, Wal-Mart Stores, Walt Disney, Microsoft, 3M, Procter & Gamble, Coca-Cola, Johnson & Johnson, Dominion Resources, McDonald's, and Chevron. Motley Fool newsletter services have recommended creating a diagonal call position in 3M.Motley Fool newsletter services have recommended creating a diagonal call position in Wal-Mart Stores. Motley Fool newsletter services have recommended creating a bull call spread position in Microsoft. Motley Fool newsletter services have recommended creating a diagonal call position in Johnson & Johnson. Motley Fool newsletter services have recommended creating a written covered strangle position in American Express. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.