Thursday, October 16, 2008

Understanding The Dow

Due to recent volatility in the Dow Jones Industrial Average (DJIA), the public has taken a new found interest in the daily fluctuations of this index. Is the DJIA a decent proxy for the US market? It actually has several weaknesses when used in this regard. To understand why, it's important to understand how the DJIA is calculated.

First of all, the DJIA is what's referred to as a price-weighted index, meaning its movements are related only to the stock price movements of its components. This means a company with a huge market cap with a low stock price has less influence on the index than a smaller company with a high stock price!

This also has the effect of lowering the influence of successful companies that split their stock as they grow: if a company decides to split its shares 2:1, a 10% increase in the now halved stock price has less influence on the index than it did when the share price was higher! As such, we may expect the DJIA to have lower returns than the broader market. (We looked at the DJIA returns over time here.)

Finally, the DJIA is comprised of 30 large, mature, blue-chip stocks (listed here) that are not representative of the thousands of US stocks out there. As such, its returns are not comparable to those of the NYSE or NASDAQ as a whole. In future posts we'll consider the suitability of other indexes as proxies for the broader US market.

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