Posted Tuesday, Feb. 21, 2012, at 1:57 PM
With the Dow Jones Industrial Average back over 13,000 it's worth emphasizing that not only is the stock market different from the economy and an index of 30 large firms different from the stock market, but the Dow is constructed in an absurd manner. Specifically, it's an average of 30 different stocks that's what we call price-weighted. That means that if Acme, Inc has 1 million shares outstanding each worth $4 and Genericorp has 2 million shares outstanding each worth $2 you average them out to a price of $3. In a properly constructed index, what you need to do is weight by total market capitalization and see that Acme, Inc. and Genericorp are the same. Doing the weighting the way the Dow does it has no advantages other than preserving historical continuity of a very old time series.
Joe Weisenthal in defense of the Dow has been noting its very high correlation with other, broader, more sensible indexes. I see this as further undermining the Dow's legitimacy. If it's very different methodology were leading to some kind of meaningfully different result, then we could perhaps argue that it's adding value in some kind of way. But instead what's going on is that the Dow's creators are hand-picking which stocks to include in the index specifically with an eye toward constructing an index that mirrors the other, better indexes out there. Apple and Google, for example, aren't in the Dow and aren't doing to get in any time soon because their very high share prices would skew the index in weird ways. This just goes to show that the Dow's creators already "know" the right answer (from looking at the S&P 500 and the Wilshire 5000) and then are trying to assemble an index to create the predetermined result. It's fine as a publicity stunt for the various firms that have owned the rights to the DJIA over the decades, but it makes no sense to refer to it as an indicator of anything other than the index-makers' tradecraft.