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(Mary Altaffer/AP)
(Mary Altaffer/AP)

Inside the Market

Hard-to-beat Dow index's big lesson for investors: Keep emotion out of it Add to ...

The Dow Jones industrial average takes a lot of abuse as an index. It’s narrowly focused on just 30 stocks, weighted based on share price and constructed on the whims of a committee.

So why is it so hard to beat? The answer just might make you a better investor.

The Dow isn’t a common benchmark upon which mutual fund managers and other investors judge their performance. That role is usually reserved for the S&P 500, especially if you’re focused on U.S. stocks. It is common knowledge, or at least should be, that fund managers struggle to beat the S&P 500 in any given year, and 70 per cent of them fail to do so over any 10-year period, according to the author Charles Ellis.

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It’s safe to say that most investors are also underperforming the Dow, given that it has beaten the S&P 500 over the past five- and 10-year periods, after factoring in dividends. This gives the index a baffling credibility boost. The Dow is not designed to beat anyone, but merely reflects in some limited way the economic and industrial might of the United States. Its overseers select stocks based on fairly flimsy criteria, including a company’s reputation, its ability to show sustained growth and its interest to a large number of investors.

More controversially, stocks are weighted based on price rather than a company’s market capitalization. This means that Walt Disney Co. has twice as much influence as Microsoft Corp., even though Disney is half the size.

And while other stock market indexes select member stocks based on objective criteria (say, the 500 biggest stocks), Dow membership is overseen by fallible humans – just like, well, mutual funds. But these downsides haven’t made the Dow into some sort of lumbering hippo that cheetah-like investors can run circles around. In fact, the Dow has gained 8.7 per cent annually over the past 10 years, 0.9 percentage points more than the average U.S. large-cap equity fund, according to Standard & Poor’s. The difference adds up.

Clearly, the Dow has something going for it. Though stocks are selected by a committee, these human overseers make few judgment calls on performance.

Chris Philips, senior investment analyst in Vanguard’s Investment Strategy Group, pointed out that any sort of automating process takes out one of the biggest hurdles to investing: Human behaviour, or the unwillingness to buy, sell or rebalance.

In the case of the Dow, stocks may come and go from the index – there have been 48 changes since its formation in 1896 – but never out of an effort to goose its performance. Stocks aren’t jettisoned because they’ve enjoyed a big runup or failed to match lofty expectations. There is no attempt made to chase new trends or hot stocks. And the index couldn’t care less about volatility, the economic backdrop or earnings forecasts.

It’s an index – flawed in design and unrepresentative of the equity landscape, but nonetheless devoid of all emotion and any ambition for outperforming everyone else.

While that might sound awful, it isn’t a drag from a performance perspective. Indeed, mutual fund managers would do well by emulating the Dow and taking a far less emotional and active approach to investing. As for regular investors who buy and sell their own stocks, the Dow also provides a fine lesson in money management: Don’t try so hard.

Follow on Twitter: @dberman_ROB

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