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After 40 years, Apple (AAPL) is finally added into the Dow Jones Industrial Average, a nearly 120-year-old index. Getting booted out is AT&T (T), a telecommunication company based in Dallas, Taxas. So, one might ask why did it take the index editors a long time to include Apple, a company of $740 billion market capitalisation?

It may have to do with the way it uses price weightings to its constituents. A full detail can be found here. A key concern for many investors as a measure of well-being of the US economy is best explained as follow: Companies with higher stock prices like Visa (V) have higher weightings (9.7 percent) in the portfolio, whereas the companies with lower stock prices like Walmart (WMT) have lower weightings (3.0 percent). It is however, unclear as to why Visa with a market capitalisation of $170 billion should have a significantly higher weighting than that of Walmart, which has a market capitalisation of $267 billion.

The peculiar way of calculating this index is deeply rooted in the creation of the index. Planet Money has a great cover on this history. To put it simply, back in 1896 there was no computer, so the people decided to do the simplest thing, adding the prices together. That gives you an index. Over time they realised that it is not a useful way of measuring the state of the market, but its methodology remains unchanged because of its perceived historical value.

A question remains: how well does it correlate with S&P 500 index? Justin Lahart recently compared the monthly changes between the two indices, and found the Dow tracks S&P 500 quite closely. In his words,

Since 1950, the monthly change in the S&P 500 has had a 96% correlation with the Dow’s. What’s more, the magnitude of those changes closely match each other: A 1% monthly change in the Dow has been associated with a 1.03% change in the other index. There are differences between the two, but for investors looking for a daily yardstick of the market, they amount to fractions of an inch.

Here is a pretty graph.

Monthly changes in the Dow vs S&P 500. Source: WSJ

So, its relevance to investors today is at best on the same par as S&P 500 with longer historical data. Perhaps, it would be more efficient to pay less attention on the Dow.

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