Why the Dow—Quirks and All—Is Beating the S&P 500 – By Jason Zweig

This coming week, the dowager gets a makeover. The Dow Jones Industrial Average, which turned 117 years old this summer, will get three new members as Nike, Visa and Goldman Sachs Group replace Alcoa, Hewlett-Packard and Bank of America.

Should you care? There will be no immediate impact on the level of the Dow, which finished this week at 15376; the three stocks getting the boot have barely budged in price. But the inner workings of the average, which have changed little since its inception, hold some important lessons for investors—most notably that things on Wall Street are seldom as simple as they seem.

The changes to the Dow “were prompted by the low stock price” of Alcoa, H-P and Bank of America and by the “desire to diversify…the index,” S&P Dow Jones Indices, which oversees the Dow, said in a statement. Dow Jones, publisher of The Wall Street Journal, owns a stake in the index company, which is a unit of McGraw Hill Financial.

Wall Street professionals, who regard the Dow as antiquated and cumbersome, mostly sneered. “High priced stocks totally skew this horribly constructed index,” tweeted Kid Dynamite, a trader who runs a popular blog. The way the Dow is put together, he later told me by email, “makes no sense at all.”

The Dow consists of 30 stocks; the higher its share price, the more a stock influences the level of the index. At its recent price of $192, International Business Machines has the largest weight in the Dow, at 9.6%—while Alcoa, at $8, makes up just 0.4%. A 1% rise in IBM’s share price would add roughly 15 points to the value of the Dow, while a 1% jump in Alcoa’s price would add only 0.6 point.

That method of building an index, called price weighting, differs from “value weighting,” in which stocks with a greater total market value (regardless of their per-share price) loom larger. The market value of IBM’s shares totals $209 billion—but that gives it only the 12th largest position in the value-weighted S&P 500, at 1.32% of the index. Instead, Apple—total market value, $429 billion—has the biggest weight in the S&P 500, at 2.92%.