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April 21, 2017

Don't Trust The Dow As An Indicator: Diversification Is Your Friend!

Almost very financial report on radio or TV features a breathless recitation of the state of the Dow Jones Industrial Index as if it were the gold standard of measurements of the state of the economy.

But as any statistician will tell you, using only 30 companies to gauge the state of a group of almost 4,000 publicly held companies that trade stock is a recipe for some odd fluctuations that do not reflect reality. Add to that the fact that the Dow is not randomly selected, and that only a tortured definition of "industrial' would allow inclusion of American Express or Walt Disney, and you get a warped picture of the economy.

A better measure is the S&P 500, or the Russell 2000, or the Wilshire 5000.

The S&P 500 is a group of the largest companies in the country, the Russell 2000 is the bottom 2,000 companies in the Russell 3000, and the Wilshire 5000 is pretty much every company publicly traded in America.

Here's a five year graph showing the S&P 500 and the Dow...


And here is one showing the Dow vs. the Wilshire 5000 (a fund that reflects it), because it's a better comparison, which was suggested by commenter Hopped Up On Something.

dow wilshire.jpg

With only 30 components, any sharp movement caused by any number of things can move the Dow in ways that do not reflect the economy as a whole. Just imagine an iPhone battery problem or a Chevron oil refinery fire or a trading scandal at Goldman Sachs and you can see how easily a catastrophe for one company in the Dow can skew it significantly, when the larger economy shrugs it off as a nothing-burger.

Unfortunately the best measure of the economy, internet pron site hits, is not yet available.

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posted by CBD at 11:30 AM

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