Friday, September 17, 2010

The Problem with a Poorly Weighted Dow 30

I’ve always been annoyed by how the constituent members of the Dow 30 are weighted (i.e., based on the price of each company’s shares), but current weightings are really ridiculous in that only a handful of the 30 stocks have any meaningful influence on the value of the index.

Why is this a problem? Because the Dow is considered (although wrongly) to be a barometer of the health of the entire economy. If the Dow is doing poorly, it influences the psychology and behaviors of consumers and business leaders. With a poorly constituted index, as is the case now, false indications can more easily result, which is potentially harmful, as a negative trend in the Dow could trigger behaviors that could cause a recession.

Do we really want the price movement of three or four stocks to influence the psychology of the country, if not the globe? Some of the current heavy hitters in the index, like IBM and McDonalds, are doing fine now, but they had significant business issues within the past 20 years that dramatically deflated their stock values and which had nothing to do with the state of the economy as a whole. That could certainly happen again, and it's nothing trivial. Obviously, I'm dramatizing the risk somewhat to illustrate my point, but why unnecessarily create risks, especially after what we've been through over the past couple of years? The public is tired of having its fortunes dictated by Wall Street.

Given that price per share is simply a function of how many shares are outstanding, which has no relevance to anything, why not base the weighting on something more rational, like market cap, or why not even do an equal weighting?

Here’s a good explanation of what’s going on, in case this subject is new to you.

Click here for a link to the article that the video is from.