Posted Tuesday, March 5, 2013, at 10:13 AM
Photo by Spencer Platt/Getty Images
The Dow Jones Industrial Average reached a new all-time high today. The smart critique of celebrating this fact is that, in inflation-adjusted terms, it's still about 8 percent off its 2000 peak.
But that's not even the real problem. The real problem is that the Dow is a nonsensical index. When you're compiling a stock index, you need to think of a way to weight the different components. The correct way to do this is to weight companies according to their market capitalization. You take the price of one share of a company, multiply it by the total number of shares and then you have the value of the company. Companies with higher value get higher weight. The wrong way to do weighting—the DJIA way—is to simply weight by price. So if one share of Acme is worth twice as much as one share of Genericorp, then Acme gets twice the weight of Genericorp even if there are four times as many Genericorp shares in the world than Acme shares.
This is clearly wrong, which is why no other important stock index is weighted this way. And in fact because the Dow is misweighted, it would give you crazy results if Dow components were selected according to any objective criteria. Consequently, Dow components aren't selected according to objective criteria. Instead, the index is "hand crafted" to avoid stocks whose prices would unduly skew the index due to price weighting. The goal is to hand craft an index that will more or less mirror the performance of a proper index like the S&P 500 or the Russell 2000. And the people who do it do a pretty good job of it. So congratulations to them. But if you want to look at a market indicator of something, you can just go look at a properly constructed index.