Aurora Borealis
1 November 1979 Financial Analysts Journal Volume 35, Issue 6

The Revised Dow Jones Industrial Average: New Wine in Old Bottles?

  1. Andrew Rudd

The Dow Jones Industrial Average is neither a reliable indicator of market sentiment nor an accurate measure of market performance over time. Because each component asset’s contribution to the index is proportional to its price, the DJIA, like any price-weighted index, tends to be dominated by a few companies. In fact, 10 companies account for over half the value of the current average; the DJIA is thus more representative of the price movements of these few companies than it is of the price movement of the stock exchange’s overall list. Furthermore, weightings in the average change as share prices change; the instability of the index over time makes it a poor indicator of long-term market movements.

The techniques of modern portfolio theory allow us to measure with some precision the extent of the DJIA’s instability over time and its divergence from general market movements. An index that purports to indicate general price movements should exhibit the same response as the market to changes in the economic environment. The ideal index would have the same level of systematic risk, or beta, as the market as a whole It should also exhibit a low level of residual risk relative to the market. An index that is concentrated in certain sectors or industry groups will be inadequately diversified.

The DJIA has a lower systematic risk level than either the New York Stock Exchange or the Standard & Poor’s 500 index. It will thus tend to underperform the market over the long term, since riskier stocks are expected to outperform less risky ones. The residual risk of the DJIA is substantially greater than either the S&P 500’s or the NYSE’s; its residual risk level is comparable to that of a bank pooled fund. While the recent introduction into the index of IBM and Merck reduced the DJIA’s residual risk somewhat, the index is still heavily concentrated in large capitalization stocks relative to the NYSE list.

The DJIA does have one invaluable virtue—timeliness. Each of its 30 stocks trades so frequently that it is possible to compute the value of the index from transactions executed within the last few minutes. The Dow is uniquely useful as an index of short-term market movements.

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