Why Use The Dow Jones Industrial Average?
Naturally occurring shifts in investor sentiment affect all stock indexes, but their effects are most clearly—and, we believe, most reliably—seen in the Dow Jones Industrial Average (DJIA). Our confidence in the DJIA’s suitability for this purpose stems from the reliability of the algorithms we developed to anticipate stock market losses. These algorithms, when applied to the DJIA, have proven more reliable than those based on the S&P 500.
We attribute this reliability to specific characteristics of the DJIA:
- It has consisted of 30 companies and has maintained consistent construction techniques throughout its more than 100-year usable history, making long-term historical comparisons more reliable.
- The companies included tend to be high quality and efficiently priced, making naturally occurring shifts in sentiment more apparent.
- Its stock-weighting scheme avoids reweighting all stocks simultaneously, reducing the risk of abrupt changes.
- It is not capitalization-weighted, which helps it avoid placing excessive weight on companies and sectors that have experienced strong recent performance.
In contrast, the S&P 500 stock index, while it also has a long history, has undergone changes in its construction rules over time. The S&P 500 currently employs a float-adjusted capitalization-weighted scheme, periodically reweighting all holdings at once. This approach tends to assign higher weights to sectors that have experienced unusually strong performance.
Some indexes—such as the NASDAQ—tend to be more influenced by company-specific events and trends, which can obscure the effects of these natural shifts. Therefore, understanding how naturally occurring sentiment shifts affect the DJIA offers valuable insights into their impact on other stock indexes.
Jeffrey Hansen, Founder of CPM Investing, was the Director of Consulting for Russell Investments' Tokyo office and a member of the team that developed the Russell-Nomura indexes for the Japanese stock market. Russell Investments has been a leader in creating rules-based stock indexes, such as the Russell 2000. At CPM, we recognize the merits of cap-weighted indexes, particularly the Russell Indexes, for a wide range of applications.