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The Daily Dow LEXINGTON, KY. (August 19): When Michael O'Higgins' book (Beating the Dow) started the popularity boom for the High-Yield Dow Approach, it seemed pretty obvious which index we should measure our returns against. After all, the stocks we invest in are all from the DJIA, so it makes sense to beat the Dow, right?
But for years, people have argued that the DJIA is a poor indicator of the overall market (three big oil stocks? And Woolworth?) and find the S&P 500 a better measure. So, while even though the "Dow" is thought of by most people as "the market," the industry uses the S&P 500 as its principal benchmark. (The fact that the DJIA and the S&P 500 seem to move virtually hand-in-hand over time seems largely to go unnoticed and tends to make the debate moot, but hey, without debate, where would we be?)
But my biggest complaint with the Dow isn't its composition of 30 stocks, but the fact that it's price-weighted and adjusts for splits the way it does. A price-weighted index measures total dollar movements of the stocks in the index, not percentage movements, so a $1 gain in Woolworth (trading near $22) is registered precisely as is a $1 gain in United Technologies (trading nearly $100 a share higher). Obviously if your stock is going to move a dollar, of the two, you'd rather be holding Woolworth, right? But the Dow isn't measured that way, so the smaller stocks are over-shadowed. And with this years' top performer being none other than Woolworth (up some 60% on the year), one wonders how the index's return is skewed by this peculiar weighting.
The other thing I don't like about the way the DJIA is computed is that the price-weighting tends to lock in gains on stocks that split. The DJIA is derived by adding the share prices of all 30 stocks and applying a flexible divisor, which can be adjusted when events like stock splits and spin-offs occur to keep the index neutral after the event. But with price weighting, a stock which has split after a big gain loses its power to move the index, so the effect of the gain is locked in to the index. It would take a much larger percentage loss at a stock's lower price to affect the index as much as the stock's gain did before it split.
So, does any of this matter for the Dow Approach investor? Not a great deal, but one way to make the comparison more relevant is to compare one's portfolio, not against the return for the DJIA itself, but against a composite return for all 30 stocks, assuming an equal-dollar investment in each stock. Such a composite would treat that 60% gain in Woolworth more fairly and provides a more realistic measure of how one is doing against "the market." Just food for thought. (By the way, we record the returns for such a composite each weekend in the Dow Statistics Center file called "1996 Dow Returns." Look for the line called Dow 30 w/ Div.)
Fool on!
Transmitted: 8/19/96
Today's Dow Numbers
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