A Better Way to Win With Dow Stocks

The Dow Jones Industrials Average (INDEX: ^DJI) gets more attention than any other measure of the stock market in the world. But if you follow the Dow, you might be surprised to learn that one of its idiosyncrasies has held it back from even larger gains over the years.

I'll reveal a way to invest in Dow stocks that market researchers have shown beats the Dow average itself over the long haul. But first, you need to learn what it is about the Dow that creates some distortions that few other market measures have to deal with.

Divisors and the Dow
The biggest positive of the Dow is that it's by far the simplest way to gauge the stock market. All you have to do to calculate the current value of the Dow is to take the share prices of all 30 components, add them up, and divide by a certain number known as the divisor. The result gives you the average.

So what's the divisor? Well, when the average first came out, the divisor was 12, because there were only 12 stocks in the Dow. Since then, every time there's been some sort of corporate action -- a merger, stock split, or other event that materially changes the price of one of the components -- the folks who manage the Dow adjust the divisor to avoid any inconsistencies. As a result, the divisor currently is 0.132129493 -- meaning each $1 of share-price value among the Dow 30 stocks corresponds to about 7.57 Dow points.

But a $1 move for some stocks means a lot more than a $1 move for others. For the highest-priced stock in the Dow, it's just half a percent. But for the smallest, it would be a 12% move! For all intents and purposes, that makes the smallest stocks in the Dow almost irrelevant.

Making a fairer index
But what if, instead of using price-weighting, as the Dow currently does, we simply took all 30 stocks and weighted them equally? That would let each company in the Dow make an equal contribution to its overall return.

A few years ago, financial expert John Mauldin consulted with stock market historian Rob Arnott to get an answer to that question. The results of their research were fascinating. Some highlights:

  • Adjusted for dividends, the original Dow stocks returned 8.9% annually.

  • Using a market-cap-weighted strategy, as the S&P 500 index and most other indexes do, boosted those annual returns to 9.1%.

  • But equal weighting allowed the Dow stocks to grow at a 10.4% annual rate, which over an 80-year period amounts to a Dow level that would be triple its current figure.

The conclusion Mauldin draws is that equal-weighted indexes tend to do better than either market-cap or price-weighted measures.

Why does it work?
I did a simpler version of Mauldin's research, looking back at the past 10 years for the Dow. I found that an equal-weighted portfolio of Dow stocks beat the actual Dow by a little more than a percentage point annually.

Two groups of stocks had a sizable impact on the results. Energy stocks ExxonMobil (NYS: XOM) and Chevron (NYS: CVX) both earned returns that were well above the Dow's average over the past 10 years, as oil rebounded from extremely low levels in the late 1990s and early 2000s to their current level near $100 per barrel. Conversely, big-box retailers Home Depot (NYS: HD) and Wal-Mart (NYS: WMT) started out the decade with fairly high valuations, and their shares didn't make much headway even as their respective businesses grew into those valuations. But because their shares carried above-average prices in 2002, their subpar performance had a larger impact on the actual Dow than on an equal-weighted index.

What to do
Equal weighting won't always outperform other methods of creating benchmarks like the Dow. But before you blindly buy a Dow-tracking ETF, consider whether you really have more conviction about the high-priced stocks in the average than the lower-priced ones.

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At the time thisarticle was published Fool contributorDan Caplingeris always looking for better ways to invest. You can follow him onTwitter. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Wal-Mart.Motley Fool newsletter serviceshave recommended buying shares of Home Depot, Chevron, and Wal-Mart, as well as creating a diagonal call position in Wal-Mart, while a separate newsletter service formerly recommended shares of Wal-Mart. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Fool'sdisclosure policyis the best way we know.

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