The Dow Jones Industrial Average Is a Big Lie

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The Dow Jones Industrial Average is the most inaccurate and distorted of all stock indices - and yet it remains the most followed stock market index.

Many of the Dow's flaws are well-known, but that hasn't stopped people who should know better from following its every move.

Dow Jones Industrial AverageThere are plenty of reasons why the retail investor needs to take the Dow Jones Industrial Average with a grain of salt.

Even the most basic aspects of the DJIA are flawed. When Charles Dow created the index in 1896, it consisted of 12 companies. In 1916 the number was increased to 20, and in 1928 increased again to 30, where it has remained.

In both of those cases, and more than 50 times in the history of the Dow Jones Industrial Average, the component companies were changed. Such changes led to the creation of a clunky method to keep the index price consistent, the "Dow Divisor."

The problem is that all those changes have invalidated the usefulness of an index.

Think of it like this: You can compare the price of General Electric Co. (NYSE: GE) stock today to GE stock in 1975, 1985, and 1995 and know (as long as you've adjusted for stock splits) that you're comparing apples to apples.

But the Dow components of today are different than the Dow components of 1975 or 1985 or even, for that matter, 2005. With the Dow Jones, you're comparing apples to oranges to pears to mangos.

Another huge problem with the Dow is how it's weighted, using price instead of market cap.

That means oil giant Exxon Mobil Corp. (NYSE: XOM), priced at about $100 a share, has less weight in the index than Goldman Sachs Group Inc. (NYSE: GS), which trades at about $160 a share, even though Exxon Mobil has a market cap six times larger than Goldman's.

So a Dow component with a low stock price can make a huge move up or down and barely budge the index, but a component with a high price can cause significant changes in the index with much smaller moves.

But it's another quirk of the Dow Jones Industrial Average, one that few people consider, that really calls into question any value it might have as a valid measure of the markets.

The Dow Jones Industrial Average Is Skewed Toward Winners

Remember those 50-plus changes that have been made to the Dow Jones Industrial Average over the years? The impact of those changes on the Dow is much more dramatic than making the index essentially different over time.

The managers of the Dow Jones Industrial Average make changes to the components supposedly to ensure the index continues to provide an accurate snapshot of the U.S. economy.

But if you look at the history of those changes, invariably market losers are replaced with market winners - which create a bias in the Dow toward more rapid increases.

Money Morning reader Wim Grommen, a mathematics teacher in the Netherlands who has studied the peculiarities of market indices for the past 15 years, wrote to us about this pattern.

"The manner in which the Dow index is maintained actually creates a kind of pyramid scheme," Grommen explained. "All goes well as long as companies are added that are in their take-off or acceleration phase in place of companies in their stabilization or degeneration phase... It greatly increases the chance that the index will rise rather than go down."

Our Chief Investment Strategist Keith Fitz-Gerald has talked about this with Money Morning readers a number of times - and concurs.

In particular, Grommen notes that since 1980 seven tech and telecom companies and five financial companies have been added to the index. Both groups have experienced massive growth in the decades since - growth that closely coincides with the DJIA's rapidly rising trajectory from about 900 in mid-1980 to 10,000 and beyond in the years that followed.

This distortion to the upside is built in to the Dow Jones Industrial Average. It's one more reason investors should not trust the DJIA as any kind of serious measure of the health of the U.S. economy or the markets.

Despite all its flaws, both mainstream and financial media will continue to focus a lot of attention on the Dow Jones Industrial Average. That's because, as Fitz-Gerald notes, the Dow is familiar, so it's like quoting an old friend - and it's been around a long time, so there's an institutional memory.

Bottom line: Most investors would be far better served by following more diverse and stable indices such as the Standard & Poor's 500, or the even broader Russell 2000.

What is your preferred index to measure the markets? Share your ideas on Twitter @moneymorning or Facebook.

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