The Dow Jones is not a benchmark, though the media and others like to use it as such. The weird thing about this particular average is that you couldn’t easily replicate its returns with a simple buy and hold strategy. Sure, you could buy an exchange-traded fund like the DIA etf, but you cannot recreate the performance of the DJIA like you could the S&P—by purchasing the stocks in equal weights.
What is Price Weighting?
Price weighted averages are those that do not take into consideration the current market cap or value of an individual stock into calculating a share’s representative value in the fund. Instead, the Dow Jones works on a price weighting system that essentially says the Dow is to move by X number of points for each $1 change in the value of the companies that make up the Average.
Note: Take notice of the difference in the Dow Jones Industrial Average and the S&P 500 Index. Those two words—index and average—have much to do with what they do and how they’re intended to work.
The difficulty with the Dow, and any price weighted market average, is that the Dow can and will rise and fall on very small changes in its component companies. Say, for example, ABC company sells for $100 per share while XYZ company trades for $10 per share. ABC company could rise by $1, a one percent move, and XYZ company could fall by $1, a 10 percent move, and the Dow Jones Industrial Average would not move a single one-hundredth of a point.
See the problem? By basing the DJIA on share price, instead of percentage values, a larger company with a smaller share price moves the Average by far less than a much smaller company with a larger stock price on the same percentage movement. Goofy, huh?Tags: Finance