
Why the Dow is a useless market index - qwerty2020
http://erikrood.com/Posts/DJIA.html
======
schwarrrtz
Relevant episode of Planet Money:

[http://www.npr.org/sections/money/2017/01/04/508261371/episo...](http://www.npr.org/sections/money/2017/01/04/508261371/episode-443-dont-
believe-the-hype)

"It's no secret that we here at Planet Money think the Dow is a terrible
economic indicator. We don't like that it only looks at thirty companies. We
don't like the way it does its math. We think it does a bad job reflecting the
overall economy. Honestly, we're not sure why everyone is still talking about
it."

~~~
tempodox
> Honestly, we're not sure why everyone is still talking about it.

It's like telling a compulsive gambler their favourite “system” won't predict
luck. They just don't want to hear that.

~~~
hueving
Not really, it's not predicting the future like a gambling system. It's just a
measurement people are familiar with because they have reference points in
mind.

~~~
kazagistar
The phases of the moon are also a familiar measurement system for which people
have reference points in mind.

~~~
grogenaut
The phases of the moon are pretty good for predicting moon rise, moon set,
time of month, days of the year, days, and the tides.

------
Animats
The DJIA is just the sum of 30 stock prices, divided by a "divisor" which is
adjusted to keep the value constant when a company is added or removed. The
amazing thing is that it's quite useful. But why?

One reason is a long-standing tradition that stocks should be priced in the
range 10 to 100. This tradition stems from old ticker system limitations, and
it's weaker than it used to be, but it still has some force. Stocks which get
well above 100 usually split (yes, there's BRK), and stocks which get below 10
are usually considered to be in trouble. Below 1, they're called "penny
stocks" and get delisted from the big exchanges.

As a result, successful companies tend to be near the top of the 10-100 range.
This weights them higher in the DJIA. Right now, here's the list.[1] Goldman
Sachs is the only one above 200, and they really ought to split. They might
get replaced in the DJIA if they don't. Nobody is below 10; GE, at 23, is at
the bottom.

[1] [http://money.cnn.com/data/dow30/](http://money.cnn.com/data/dow30/)

~~~
crazygringo
Fascinating. Thinking about how GOOG is $824 right now, and how it's not in
the Dow, I found:

"This quirk kept Apple from joining the index until recently. The world's
biggest tech company, despite its massive influence on the economy and the
markets, was excluded from the Dow Jones Industrial Average because its share
price of about $600 would have given it outsize influence on the index.
However, when the company split its stock 7-for-1, it became a viable Dow
addition." [1]

[1]
[https://www.fool.com/investing/general/2015/05/18/the-30-dow...](https://www.fool.com/investing/general/2015/05/18/the-30-dow-
jones-stocks.aspx)

------
nabla9
>So, next time you hear someone talk about the Dow in any serious sense,
kindly point them in the direction of an index weighted by market
capitalization (e.g. S&P 500 or Wilshire 5000),

The most commonly used index - the one that is shown in the news or discussed
with your Uber driver. should be index that provides essential information for
the average person.

I would advocate pointing people towards total return indexes of S&P 500 or
Wilshire 5000. Index's total return displays a more accurate representation of
the index's performance than price index and it can be used directly to
benchmark stocks to other investments.

Surprising amount of people are not aware that stock price index is not
accurate measurement of stock market performance over longer periods of time.

[http://imgur.com/a/uHRZ9](http://imgur.com/a/uHRZ9)

~~~
gumby
> The most commonly used index - the one that is shown in the news or
> discussed with your Uber driver. should be index that provides essential
> information for the average person.

Seriously, why? Those discussions are no different from discussion of sports
scores, and equally as relevant to the decisions people make. So who cares if
they are talking baseball, the dow, sunspots, or astrology? Or Apple vs
android?

(BTW I realized the Dow indices are nonsensical as a teen ager, so am not
defending them in the slightest)

~~~
nabla9
It's very important when people save for retirement and think about different
investment options.

There are all kinds of invest in gold snake oil salesmen around.

~~~
gumby
But they shouldn't be managing their investments on a day-to-day bases much
less basing decisions on conversations with random uber drivers.

------
pk3
I wouldn't go so far as to call it useless - anachronistic perhaps, but
useless no.

When the Dow was first calculated, real time market capitalization for
individual companies wasn't a thing. Prevailing market price was a decent
enough proxy that Charles Dow could make an index of leading industrial firms
out of prices (and price changes) alone.

As others have pointed out, over a long enough time period the Dow Jones has a
high correlation with market cap weighted indices. Its annual volatility has
been about 1.5 percentage points more a year, but average returns over any
reasonable holding period are barely different than, say, the S&P 500.

There's an even better argument against the Dow than the price weighting
though - the somewhat arbitrary company inclusions. One of the more
interesting pieces of history is IBM's 40-year 'vacation' from the Dow. If IBM
had stayed in for the 40 years after 1939 you could tack on another 5 figure
number to today's index price.

~~~
umanwizard
> When the Dow was first calculated, real time market capitalization for
> individual companies wasn't a thing

How is this possible? People were buying shares without knowing what fraction
of the company they represented ??

~~~
pk3
More in the sense that we don't realize how spoiled we are (and how the
standards have improved). I don't even have to leave this table to see the
effects of share issuance or buybacks from a public company, and it's all
updated in close to real time for me.

It's not that you couldn't make a _pretty-reasonable_ estimate, it's just that
the ecosystem is much improved and easier to roll up for the indices we follow
today. The Wilshire is from the 70s and the first flavor of the S&P came 30
years after the Dow (and was 'only' 90 firms). If you read Security Analysis
(first edition: 1934) you can still see some of this in action; it mentions
how only some statistical services (paid!) would calculate/estimate the
current number of shares outstanding.

~~~
kgwgk
I don't know what is "updated in close to real time" for you, but normally
companies disclose the number of shares outstanding and details about buybacks
programs once per quarter.

------
employee8000
It's not ideal but to call it useless is arrogant and immature. It's a decent
indicator of how the blue caps are doing in the markets. SP500 is arguable
better but the DJI isn't useless.

~~~
unabridged
No Google, No Amazon. Its an arbitrary choice of 30 companies out of the top
100 market caps based mostly on stock price and whose friends are on the
board.

I think Hacker News could come up with a better list of 30 stocks with market
cap over $30B.

~~~
employee8000
You're not disagreeing with what I wrote.

------
TheAlchemist
That's the reason why Berkshire Hathaway is out of the index, while based on
the market cap, it should clearly be in (~400B).

That being said, the correlation between DIJ and S&P is close to 100% so for
all practical reasons (from a long term investor point of view) it should be
OK.

------
dkrich
I see a couple of problems with these arguments. First, the assumption that
market capitalization is more important for weighting a market index than
share price. I'd argue that if your goal is to measure the health of the
overall stock market, companies that control the most money should be weighted
not much more than less valuable companies. Just because Wal-Mart, Amazon, and
Costco are doing great, doesn't mean that JCPenny, Macy's and smaller
retailers that employ hundreds of thousands of people are doing great. Giving
more weight to smaller companies introduces more companies than just those at
the top of the value spectrum. A company with massive resources can probably
weather certain negative economic variations better than smaller companies, so
to focus solely on those to the exclusion of all others seems to be willfully
ignoring a significant part of what comprises the overall market.

The other issue is that even though the S&P is cited as being a much better
index to track the market, the fact is that the Dow and the S&P correlate
almost identically historically. So even if the Dow is reasoned to be much
worse than the S&P, history shows that they both reflect basically the same
thing.

------
hl5
I guess all the Dow futures and options traders should just pack up and go
home? Dow trading is as useful as any index with volume in analyzing herd
behavior. It's a far better prospect than analyzing any of it's individual
components in isolation.

------
eb0la
Not so useless: you can construct hadge fund-like trading strategies with the
DOW and SP500.

Both DOW and SP500 have some tendency to go up and down at the same time in
bull and bear market times.

When this happens you can (for instance) short DOW and long SP500 and your
losses in the sort side will be covered by the gains in the logn side...

...but they will be uncorrelated for short periods of time. So, if your short
possition goes down while your long is constant or goes down _much slower_
than your short, then you're making money.

Probably you can make this kind of hedging with very little money (or almost
free) using the fee you get from going short to buy the long leg of the
spread.

~~~
tempestn
So all you need to do is predict the future to know which way to go
long/short, and... profit!

------
netcraft
Ive heard similar complaints for years and it makes sense to me - what doesn't
is why alternatives arent used or created? I don't understand everything about
stock markets or certainly their politics but it seems on the surface that if
you had a better indicator of the economy itd be pretty easy to show its
usefulness. And with historical data you should be able to replicate a new
index and measure its effectiveness.

~~~
loeg
The S&P500 is a fine index. People just use that instead.

------
obblekk
tldr: The Dow 30 index is a bit absurd, however it's not as bad as it seems
because of portfolio theory.

The Dow 30 correlates highly with the S&P500 index over medium-long periods of
times (approx more than a month) [1]. This correlation is due to the fact that
the 30 stocks that are selected are arbitrary but not random. They are
selected by a human process which considers which companies contribute an
important factor to the overall market [2]. Of course this process will be
imperfect because it's vague, however it gets pretty close.

Don't forget, according to findings from portfolio theory, it's possible to
replicate an index with only a small subset of the components of that index
[3]. There's a whole field of work describing how to do this [search google
for 'replicating index'],

In fact, replicating an index with a small number of stocks is exactly how
'smart trading' companies like wealthfront and bettermint make money. They
find multiple non-overlapping subsets of the S&P500 which correlate strongly
with S&P500 performance. Then they buy subset A, and if a loss is incurred in
any month, they sell subset A and buy subset B. Since A and B are highly
correlated with each other (ideally r>.99) and with the S&P500, the investor
should expect the same return in the future, however can book a capital loss
which creates a tax refund. Shifting from subset A to subset B avoids a wash-
sale allowing the capital loss to be recognized [4].

The Dow 30 is certainly not an optimal index, however it's a case study in
showing how selecting the "top" companies for some reasonable definition of
"top" will earn a return approx. equal to the market (represented by S&P500)
no matter the strategy (in this case price-weighting instead of mkt cap
weighting can be considered a strategy).

The reason it's cited so widely is that there's a lot of historical data on
the Dow 30, whereas every other index is less reported.

[1] Yahoo Finance comparison of Dow 30 vs. S&P500 chart
[http://finance.yahoo.com/chart/%5EDJI#eyJjb21wYXJpc29ucyI6Il...](http://finance.yahoo.com/chart/%5EDJI#eyJjb21wYXJpc29ucyI6Il5HU1BDIiwiY29tcGFyaXNvbnNDb2xvcnMiOiIjMWFjNTY3IiwiY29tcGFyaXNvbnNHaG9zdGluZyI6IjAiLCJjb21wYXJpc29uc1dpZHRocyI6IjEiLCJtdWx0aUNvbG9yTGluZSI6ZmFsc2UsImJvbGxpbmdlclVwcGVyQ29sb3IiOiIjZTIwMDgxIiwiYm9sbGluZ2VyTG93ZXJDb2xvciI6IiM5NTUyZmYiLCJtZmlMaW5lQ29sb3IiOiIjNDVlM2ZmIiwibWFjZERpdmVyZ2VuY2VDb2xvciI6IiNmZjdiMTIiLCJtYWNkTWFjZENvbG9yIjoiIzc4N2Q4MiIsIm1hY2RTaWduYWxDb2xvciI6IiMwMDAwMDAiLCJyc2lMaW5lQ29sb3IiOiIjZmZiNzAwIiwic3RvY2hLTGluZUNvbG9yIjoiI2ZmYjcwMCIsInN0b2NoRExpbmVDb2xvciI6IiM0NWUzZmYiLCJyYW5nZSI6IjF5In0%3D)

[2] Dow 30 index is built and maintained by a subsidiary of News Corp.
[https://en.wikipedia.org/wiki/S%26P_Dow_Jones_Indices](https://en.wikipedia.org/wiki/S%26P_Dow_Jones_Indices).

[3] [http://www.etf.com/etf-education-center/21038-how-to-run-
an-...](http://www.etf.com/etf-education-center/21038-how-to-run-an-index-
fund-full-replication-vs-optimization.html)

[4]
[http://www.investopedia.com/terms/w/washsalerule.asp](http://www.investopedia.com/terms/w/washsalerule.asp)

~~~
loeg
That isn't how the robo-advisors actually implement tax-loss harvesting. They
just buy slightly different index funds.[0]

E.g., VTI vs SCHB. VTI tracks the "CRSP US Total Market" index, while SCHB
tracks the "DJ Broad US Market" index (note, this is not the same thing as the
DJIA). Those indices are not comprised of disjoint subsets of the total stock
market.

Additionally, large index funds have enough capital to just buy all of the
components (100s-1000s) without sampling. Thirty funds doesn't really do it
justice. It can also miss out on big winners, which is where lots of growth
comes from.[1]

[0]: [https://research.wealthfront.com/whitepapers/tax-loss-
harves...](https://research.wealthfront.com/whitepapers/tax-loss-harvesting/)
[1]:
[http://www.efficientfrontier.com/ef/900/15st.htm](http://www.efficientfrontier.com/ef/900/15st.htm)

~~~
obblekk
I believe this is not allowed by the IRS because ETFs tracking similar indices
would be considered 'substantially identical', but I'm not sure [1]. If it is
allowed, then you're right - this would be the most efficient way to implement
tax loss harvesting.

    
    
      A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you:
     1. Buy substantially identical stock or securities,
     2. Acquire substantially identical stock or securities in a fully taxable trade,
    
     3. Acquire a contract or option to buy substantially identical stock or securities, or
    
     4. Acquire substantially identical stock for your individual retirement account (IRA) or Roth IRA.
    

[1]
[https://www.irs.gov/publications/p550/ch04.html#en_US_2016_p...](https://www.irs.gov/publications/p550/ch04.html#en_US_2016_publink100010601)

~~~
loeg
Different indices are not substantially identical.

Different ETFs tracking the _same index_ (e.g., SWPPX and VOO) are likely to
be determined substantially identical. (I don't know that the IRS issued
guidance on this yet.)

Yes, they choose different indices precisely because of wash sale rules.

------
ChuckMcM
It is nice to see someone dig deeply into what the numbers actually mean, but
it is surprising to see them come away with the wrong conclusions.

The DOW isn't useless, look at this graph :
[https://www.google.com/finance?chdnp=1&chfdeh=0&chdet=149177...](https://www.google.com/finance?chdnp=1&chfdeh=0&chdet=1491778123622&chddm=502044&cmpto=INDEXDJX:.DJI;INDEXSP:.INX;INDEXNASDAQ:.IXIC&cmptdms=0;0;0&q=INDEXDJX:.DJI,INDEXSP:.INX,INDEXNASDAQ:.IXIC&ntsp=0&ei=HbrqWMm9N8TxjAHv6bvIDg)
which is a comparison of the DOW, S&P and NASDAQ indices. Note how closely the
DOW and S&P 500 track each other? If the DOW was 'useless' as the author
surmises, and the S&P 500 is 'better' then why are they so closely correlated?

The answer is of course that membership in the DOW (and S&P 500) changes over
time. The selection of companies and their weighting is done by people who
look at the impact a particular company has and how its stock price 'leads' or
'trails' the market. You pick 30 of those and they become your 'signal' for
the health of the market.

~~~
JumpCrisscross
For short distances, the pre-Newtonian "ball flies straight and then drops
vertically when it runs out of oomph" math approximates Newton. It's close
enough, except when it matters. Unlike Einstein, those conditions arise
regularly. It's as easy to calculate Newton as its predecessors. The
predecessor is useless.

The Dow and S&P 500 are as easy to access. (They're similarly intensive, with
a computer, to calculate.) When they diverge, the S&P tells one more. (The Dow
only talks to industry, for which the relevant SPDR is better.)

It's uselsss. (We loved it on the trading floor, though. Retail would buy
based on the Dow. Free profits.)

~~~
ChuckMcM

       > It's uselsss. (We loved it on the trading floor,
       > though. Retail would buy based on the Dow. Free
       > profits.)
    

This is almost like the Yogi-ism "Nobody goes there any more, its too
crowded." Because in the same sentence you say "its useless" and "it gives you
free profits" (which is useful), much like "nobody goes there" and "its too
crowded" (hence lots of people _do_ go there).

I don't disagree with the assertion that as a _trading signal_ it is useless,
there is much better information around where the market is going right now,
or perhaps in the short term future. But as an _investing signal_ it serves
the purpose well, with fewer stocks than the S&P 500.

My parents for example received an inheritance and wanted to _invest_ it, so I
suggested an S&P 500 ETF fund. Doesn't cost anything for them to sit on it and
when they hear the radio say "The S&P is up 10% for the year so far" they know
that their investments are also up about 10% for the year. For a while I had a
DOW basket, actually holding shares in the 30 companies in the index. When the
DOW hit an all time high I knew my basket of stocks was worth more (as a
group) than they had been in the past.

Changes in the index did not cause my parents to make trades, instead they
just reflected changes in value of that portion of our investment portfolio.
And for that it continues to be useful.

------
rdlecler1
S&P 500 and the Dow are highly correlated (95% over the past 50 years) and so
as an overall temperature of the market it's typically sufficient.

------
gigatexal
Yup. Completely useless index.

------
teslacar
Not sure how this got to the front page. This is not new information or even
that interesting.

Literally, hundreds of articles about this exact same thing

[https://www.google.com/webhp?sourceid=chrome-
instant&ion=1&e...](https://www.google.com/webhp?sourceid=chrome-
instant&ion=1&espv=2&ie=UTF-8#q=dow+jones+price+weighted)

another brand new site up-voted to the font page...created in 2017 and only 8
very sparse articles

erikrood.com

