The Dow: Not What You Think

When people talk about the markets, I frequently hear them say “it” was up or down by some number of “points.”  They are almost always referring to the Dow Jones Industrial Average (DJIA) when they talk about “the market.”  While the DJIA does give us an indication of market movement, its construction doesn’t tell us much about either the performance of the components or the broader U.S. stock market.  Started in 1895, the DJIA only tracks the performance of thirty stocks which are meant to represent the major sectors in the economy.  Companies are added and removed periodically; this last happened in 2015 when Apple replaced AT&T and in 2013 when Goldman Sachs, Nike, and Visa replaced Alcoa, Bank of America, and Hewlett Packard.  
Last Tuesday, the DJIA fell by 1,175 points.  This was the worst point drop ever, which rattled investors.  However, the 4.6% loss wasn’t even one of the twenty worst days in DJIA history.  The worst day ever in the Dow was Black Monday (October 19, 1987) when the Dow fell by 508 points which represented a 22.6% loss…but a loss of what? That’s where the misunderstanding on the DJIA enters the conversation. The DJIA is price-weighted index which means each $1 move in component share prices has an equal impact on the index; as a result, stocks with higher share prices carry more weight.  Why would that be? 
Consider Boeing and GE which represent the two ends of the DJIA price spectrum.  Boeing closed at $332.83 per share on 2/9/18 and GE closed at $14.94. A $1 move in Boeing is a 0.30% price change, and a $1 move in GE is 6.7%. Those are two VERY different days for each stock; the former is daily noise, the latter is a really good or bad day.  While we spend in dollars, we measure Return on Investment (ROI) in percentages. ROI allows us to compare the result(s) of investing different amounts of capital (possibly over different intervals) on different investments.  So how is the DJIA calculated?
Every $1 move in a DJIA stock moves the DJIA by almost 7 points (this number changes over time to reflect changes in components and stock splits). To calculate the daily change in the DJIA, you simply take the aggregate price change of the thirty components and multiply that by 7 (it’s actually 6.885441518). To get the current value of the DJIA, you would add up the share prices of all thirty stocks and multiply it by 7.  Back to Boeing and GE – if Boeing’s share price goes up by $1 (+0.30%) and GE’s share price goes down by $1 (-6.7%), the DJIA would remain unchanged but if you had invested an equal amount in each stock, your portfolio would be down 3.2% that day.
In 2017, the DJIA rose by 4,875 points (24.8%).  Boeing’s share price increased by $138 (88%) during the year which meant it moved the DJIA by 951 points and that represented 20% of the year’s gains.  Conversely, GE’s share price fell by $14.34 per share (-45%) but that only deducted 99 points from the DJIA.  If an investor held an equal amount of the thirty DJIA stocks at the beginning of 2017, that portfolio would have returned 20.9%; while still stellar, that 3.9% difference in returns (24.8% minus 20.9%) is material – especially when compounded over time. 
In short, the DJIA will be disproportionately influenced by the stocks with the highest prices (as of 2/9/18 that would be Boeing, Goldman Sachs, 3M, United Healthcare, and Home Depot) and the stocks with the lowest prices won’t make much of a difference (as of 2/9/18, that would be GE, Pfizer, Cisco Systems, Coca Cola, and Intel.) Please don’t mistake this for a prediction of what will and won’t do well (see our other blog posts for our stance on the futility of stock picking); this is merely math. 
The bull market has pushed many of the component stocks to all-time highs, so a move of a few hundred points is just a typical day. The DJIA illustrates the aggregate movement of a sample of blue-chip stocks, but we shouldn’t confuse direction with returns.  When assessing the performance of the large-cap stocks, the S&P 500 is a much better representation. In addition to being a broader index (500 stocks versus 30), the S&P 500 is market capitalization weighted meaning the larger companies have more impact. 
In the case of the S&P 500, each company’s weight in the index is a function of the share price and the number of shares outstanding. Don’t confuse share price with company size.  As of 2/9/18, Apple’s share price closed at $156.41, which means Boeing has over twice the influence on the DJIA (based on it’s $332.83 closing price), but Apple is an $800 billion company (calculated by taking the share price times the number of shares outstanding) ,which is over four times the size of Boeing. 
While many equate the DJIA with the “market”; it’s frequently quoted, it’s often misunderstood.  

Eric Holt