Over the years, Chaim Katz had built a portfolio of small apartment buildings, and recently, in an attempt to diversify, he’d started thinking about investing in the stock market as well. But the market had its own language, which he didn’t always understand. Radio reports always spoke of the Dow Jones index (aka “the Dow”) having broken records by gaining or losing hundreds, even thousands, of “points” in a day. He wondered, What is the Dow, and is it a necessary measuring stick for the stock market? How much does the Dow’s large point swings matter to investors?

Mr. Dow Designs an Index

In 1896, Charles Dow, journalist and founder of the Wall Street Journal, designed an index to track the stock market quickly. His index combined and graphed the stock share prices of the 12 largest and most popular public companies. The idea was to have one number that could quickly provide a sense of how the stock market, and the general economy, was performing. This index was named the Dow Jones Industrial Average—Jones was Dow’s partner—and the companies originally included were all industrial manufacturers. Later, this index was expanded to 30 firms in various industries, and over the past century-plus, through world wars, depressions, political upheavals, booms, and busts, the Dow has been continually calculated and updated. Only one company of the original 12 remains in existence: General Electric, founded by Thomas Edison, and today the Dow includes iconic non-industrial companies like Apple, Coke, and Disney.

Indexes like the Dow are helpful to investors in many ways. First, they help them compare one stock’s performance to the whole group of available stock investments (“Apple is up 20% vs. the index’s 10% growth… Good job, Apple!”). Similarly, those who hire investment managers, such as through a mutual fund, can use them to benchmark the managers’ results (“Your fund is up 8% vs. the market’s 10%… What am I paying you for?”). An index can also be used to measure the stock market’s investment performance relative to other investments like bonds or real estate (which have their own indexes). The Dow index sheds an unusual perspective on the ups and downs of stock investing as it grew from 40 points in 1896 to over 29,000, a more than 700-fold increase! As the Dow’s current high level proves, despite the Great Depression (when the Dow fell by almost 90%), World War II (-35%), and decades of Cold War (-50% in 1974), long-term investors in the US stock market have been well rewarded.

Dow Falls 1,000 Points? It’s All Relative

While an index like the Dow can be a useful tool, it’s important to understand how to use it. A common error, perpetuated by the media, is to focus obsessively on the number of points in an index’s daily change. For example, the financial news fixated on the Dow’s drops of more than 1,000 points in a day in 2017 (-1,175 on February 5 and -1,032 on February 8) as if this was a huge deal. Actually, it was bad reporting, as the reports didn’t provide the proper context. A four-digit point collapse in the Dow would have been horrific in 1990, when the Dow was at 3,000, and it would have still been significant in 2005, when the Dow’s level was at 8,000 points. At the time of this report, when the Dow had hit 25,000, a 1,000-point drop equaled just a 4% fall (1,000/25,000 = 4%), something quite common for the stock market. For Chaim to succeed in his new endeavor, he must learn to ignore the media’s hype while using the valuable data they do provide.

The Dow Is a Flawed Stock Market Ruler

Although any measuring tool can be misunderstood, the Dow has some design weaknesses, which is why professional investors mostly ignore it. To begin with, because the Dow tracks only 30 stocks out of many thousands of public companies, it provides just a small sliver of insight into the market. Also, the process for choosing the few dozen firms to follow is not based on a defined mathematical or economic theory, weakening its credibility. A final fundamental failing is the fact that Mr. Dow designed the index by simply averaging the share prices of the index’s 30 components. While choosing this easy formula may have been necessary in pre-computer times, it leads to a peculiarity where a smaller company with few shares but a high dollar price per share can have a greater impact on the index than a much larger company that happens to be divided into many more shares and has a low share price. Therefore, while the Dow has earned a historic place in the financial world, it’s much less accurate and useful than today’s more sophisticated indexes like the well-known S&P 500 index.

There’s an old saying that while numbers don’t lie, you can lie with numbers. Consider a statistic that cities with many police officers have high crime rates. Even if that fact is accurate, the conclusion that cops cause crime would be a statistical lie. This extreme example shows how even real numbers can be misleading when improperly presented. While the Dow can be a useful measuring tool and provides a fantastic historical perspective on the stock market, it’s also a seriously flawed ruler. Chaim can use reports on the Dow as a convenient and quick check of Wall Street’s pulse, but he needn’t lose much sleep over its movements.