If you tune your TV to CNBC, or visit the home page of the Wall Street Journal, you’re likely to be confronted with green or red numbers bearing the name of a stock market index. DOW, NASDAQ, S&P 500, Russell 2000; the list goes on and on. They’re supposed to tell you how “the stock market” is doing. But, not all these indices are created equally. There are two big questions to ask when you’re looking at an index:
- Which stocks are included in the index?
- How do they do the math?
Over the next few months, I’ll answer those questions for a few major indices. This month, we’ll start by picking on the DOW.
First, the DOW includes only 30 companies. That’s not very many. Which companies, you ask? Well, there are no specific rules; they are chosen by a committee. Apple is included, but Amazon is not. Coca-Cola is on the list, but Google is nowhere to be found.
But, the small number of companies, and their arbitrary selection, isn’t the biggest knock against the DOW. It’s also the only popular index whose creators failed the most basic test: “does the math even make sense?” Let’s have some sympathy for them, though. The DOW was created in 1896. It was a different time. Most people didn’t have electricity yet. Ford Motor didn’t even exist. So, everyone was still riding around on horses, and those horses pooped all over the streets. I’d have trouble doing good math in those circumstances, too.
Here’s an example to show you how bad the math really is:
Let’s say only two companies existed in the whole wide world: MegaCorp, and Little Timmy’s Lemonade Stand. Megacorp is worth a trillion dollars, with a trillion shares of stock. Little Timmy’s Lemonade Stand is worth $100 dollars, with 100 shares of stock.
That means the shares of both companies are worth one dollar each. That might seem strange; one company is way more valuable than the other. But, remember, MegaCorp has way more shares.
Now, what if Timmy’s Lemonade stand tripled in value, but MegaCorp went bankrupt? Generally, is that good or bad? Good for Little Timmy, right? But, MegaCorp is a much bigger company. So, it’s really, really bad for most people in the world.
Let’s hop in a time machine to 1896 to see if the DOW people agree.
“You really should be happy about this,“ the DOW people explain. “Both stocks were worth one dollar per share. One plus one equals two. Now, one stock is worthless, but the other is worth three dollars. Zero plus three equals three. Ask anyone here in 1896—three is more than two. You should be celebrating–the market is booming!” Satisfied with their answer, they pat each other on the back, mount their horses, and ride off down the street.
You stare at the departing DOW people in disbelief. Do they not realize MegaCorp was like, a bajillion times bigger than Little Timmy’s Lemonade Stand? Do they really think this is “good news” for most investors? Do they think the size of the company is totally irrelevant? Why are they wearing such ridiculous clothes? And, why do the streets smell so bad?
We’ll answer those questions, and more, in a future article. For now, just remember that the DOW is just about the worst popular index to look at.
The content of this article is developed from sources believed to provide accurate information. The information is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation. All expressions of opinion are subject to change. This content is distributed for informational purposes only, and is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services. Past performance is not a guarantee of future results. Index performance does not reflect the expenses associated with the management of an actual portfolio.