Is The Dow Jones Index Still Relevant?

On January 25th, 2017, the Dow Jones Industrial Average hit the much anticipated high water mark of 20,000 points.

The inception of the Dow dates all the back to 1896. Only 30 stocks make up the index, and historically it contained only industrial companies such as the American Tobacco Company and US Steel. Nowadays, you'll find everyone from Apple to Chevron to Proctor & Gamble.

When your favorite news outlet comments on the stock market, you'll often hear a reference to the Dow Jones. But personally, I've never paid much attention to the Dow since it's only 30 stocks. There are more than 4,300 publicly traded stocks in the US, so why should I care what a mere 30 are doing? That's like your car mechanic only looking at your properly functioning rear brake light and saying yup, your car is running great!

I set out to write this blog post on how useless the Dow actually is at measuring the health of stock market. Before diving into the data, I was convinced an index with so little diversification would be radically different than something more robust like the S&P 500. How wrong I was...

The Perception

Last week I had a conversation with another financial advisor who works at my company regarding what the 20,000 mark actually means. Like most financial professionals, we agreed the index was an outdated relic that is largely irrelevant. We dismissed the new high and laughed when I said I should blog about how useless the index is for investors.

However, our knee jerk reactions based on what we thought was the case turned out to be based on some old school thinking. How can an index of only 30 companies actually represent the US stock market, right? What I found was pretty interesting (at least to nerds like me), so here's that blog post I joked I'd never write.

How It's Valued

The Dow is the only "price-weighted" index, meaning a stock with a higher price is assigned a higher emphasis in the index compared to a stock with a lower price. When the most expensive stock in the Dow (Goldman Sachs, $240), changes price, it drives the index to a greater degree than the cheapest Dow stock, General Electric ($30). It's a different approach to index valuation, but hey, I don't make the rules. Cool fact: actually, statistician Edward Jones came up with the methodology!

Components

According to the index's construction methodology, the Dow contains stocks that represent all industries with the exception of transportation and utilities, which are covered by the Dow Jones Transportation Average™ and Dow Jones Utility Average™ respectively. The index is largely made up of large cap stocks, but Morningstar reports a minority percentage of constituents are actually small and mid cap stocks.

A full list of stocks in the index can be found Here.

Correlation

A diversified portfolio should contain investments that are uncorrelated, i.e., they don't move in perfect tandem. This helps when one asset class is declining. The theory goes that hopefully something in the portfolio will help buffer losses, like bonds did to stocks in 2008.

When I calculated the correlation of the Dow to a more robust index, like the Russell 3000 (3000 stocks representing the entire US market) and the S&P 500 (mostly US large cap stocks), I found that statistically, there isn't any difference in correlation. Being perfectly correlated means that the Dow, the S&P 500, and the Russell 3000 all move in the same direction at the same times.

Performance & Risk

When charted over the last 17 years, the returns don't deviate much from each other.

The annualized returns are as follows: Russell 3000, 5.28%, S&P 500, 4.85%, Dow Jones, 5.10%; not a huge difference.

I also looked at standard deviation, which measures how much the portfolio drifts from its mean return. For our purposes, we can associate standard deviation with risk. Surprisingly, over the last 17 years the standard deviation of the Dow has been identical to the Russell 3000, meaning the Dow has taken the same risk with 30 stocks as the Russell and its 3000 stocks.

What This All Means

Even though the Dow contains only 30 stocks, it can still serve as an effective representation of the entire US market.

This is a fantastic lesson in that we can't let our biases dictate our positions. Before writing this post, I incorrectly assumed the Dow was just an antiquated way to describe what was really happening in the market. Even though countless amounts of academic research touting the benefits of diversification suggest the more stocks, the better, in this case an index of just 30 mostly large cap stocks can be used to model the market in terms of risk, correlation, and return.

Facts matter, and we have to adjust our considerations when new information conflicts with what we innately believe. So yes, even though it still seems a little unnatural for me to say, the Dow definitely deserves a place in the daily news.

#stocks #evidencebasedinvesting