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Why the Dow Jones isn’t the best index to follow

By October 10, 2019 No Comments

The Dow Jones Industrial Average, aka “the Dow,” is the most commonly cited stock market index. You’ll see it referenced in headlines when the day’s stock market activity is reported. If you go to google and search for stock market news on the day, you’ll see the Dow has the most results. Here are the first three returns on a search for “stock market news” from October 10, 2019:

The Dow isn’t the best way to track the market

But is the Dow the best way to understand what the stock market did on a given day? No, and here’s why: the Dow only represents 30 companies. In other words, it is not a broad-based market index. While the Dow does include companies from various sectors of the economy, it really only includes the biggest ones. As a result, it doesn’t give a good read into how medium or smaller sized companies are performing. In addition, of the 30 companies represented in the Dow, the top 5 make up nearly 33% of the index’s weighting. And the top 10 make up more than 50% overall:

Dow top holdings

What this means structurally is that these five companies have an outsized impact on the Dow’s performance. For example, if Apple, Home Depot, and Boeing all go up together or down together, they could outweigh performance that’s happening in lower weighted stocks. So when the Dow is up or down big on the day, it’s usually because the top 5 stocks were all up or down big on that day too. Granted, Apple and Boeing are very important companies, but they can’t give a consistent read into the entire market. Therefore, you don’t really know what the broader market is doing by simply following the Dow.

The S&P 500 is a better index to follow

A better index for the average investor to pay attention to is the S&P 500. As the name implies, this index is comprised of 500 companies (well actually 505, but who’s counting?). The S&P 500 is more diversified and the largest holdings carry significantly less weight than they do in the Dow. The top 5 holdings make up less than 15% of the index, compared to 33% for the Dow. And the top 10 make up just 22%, compared to more than 50% for the Dow:

The way the S&P 500 is weighted makes it a better representative for the overall market. This is important for the purpose of judging your own equity account value. (Emphasis on equity account value, if you own a lot of bonds then your account won’t follow either of these stock indexes). Someone who owns broad-based stock market index funds should see their performance track pretty closely to the S&P 500 more so than to the Dow. And you can see the way the returns for each index have varied from time to time:

The indexes don’t always move the same

The S&P 500 is up 4% more than the Dow in 2019. That’s a big deal. That’s an extra $4,000 in gains on a $100,000 account or $40,000 on a $1 million account. Yet, in the last 3 years, the Dow is besting the S&P 500 by more than 2.5% per year. However, over the last 10 years, both indexes have performed relatively the same. All of this is to say that both of these indexes are constructed very differently.

As a result, the returns for each index will vary. Sometimes by a lot, and sometimes by only a little bit. But if you want to have a more accurate read on what the stock market is doing on a given day, you should track the S&P 500. Here is a link you can bookmark to easily see how the S&P 500 is performing.

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