why professionals use the S&P 500 as a benchmark, not the Dow Industrials

the Dow at an all-time high

Yesterday, the Dow Jones Industrial Average reached an all-time high, signalling a recovery of the index past its previous, pre-Great Recession peak.  This is certainly good news psychologically, since the Dow is a very widely recognized name.  And any report that puts the downturn behind us is welcome.  As it happens, I was listening to Bloomberg Radio when the new high-water mark was first achieved.  A Surveillance commentator played down the fact that the S&P 500 had not yet recovered all its recession losses (although it’s close), saying that the use of the S&P over the Dow is “just” a question of “institutional bias.”

That’s simply incorrect.  …hence this post.

what’s wrong with the Dow

There are three reasons professional investors use the S&P 500 to benchmark their performance rather than the Dow:

1.  wider coverage.  The Dow Industrials consist of 30 American companies; the S&P, as the name suggests, has 500.

2.  greater relevance.  The Dow consists, by and large, of very mature, slow-growing firms.  No Google, no Apple, no Qualcomm, no Amazon.  No biotech.  Home Depot and Wal-Mart are the only retail stocks.

3.  Dow construction is weird.  For reasons best known to himself, Charles Dow decided not to make a stock’s total market value be the measure of its weighting in the index.  He chose the per share stock price instead.  It was probably easier to calculate.

This decision has dire effects on the index.  A 1% change in the price of IBM, whose shares sell for $206 each, counts for over 7x as much in the index as a 1% change in the price of Microsoft, even though the two companies have almost the same total market value.  Why?  It’s solely because MSFT has split its stock in the past to maintain an “affordable” share price, and sells for $28.35 a share.

That’s right.  In the Dow, even a tiny company with a high per-share stock price would outweigh a behemoth with a gazillion shares at a low per-share price.

At least Charles didn’t pick the number of letters in the company name as the weighting factor.

how to game the Dow

What would I do if a pension fund hired me as an equity manager and gave me the Dow as a benchmark?  First of all, I’d have to consider whether I’d want to work for a bunch of nut jobs.  But the strategy for beating the index is clear.  I’d try to figure out whether we’re in an up market or a down market (harder than it sounds).  If the former, I’d buy the ten companies with the highest per share stock prices.  If the latter, I’d pick the ten with the lowest prices.  Unless you were unlucky enough to have epic  clunkers like Bank of America or Hewlett-Packard (both Dow components), nothing else would matter.

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