When past performance doesn’t even predict past performance

livemint.com:

This week, the Dow Jones Industrial Average, born on May 26, 1896, turned 128 years old. Let’s pour the Dow a drink from the fountain of youth and see what happens. I’ll give you a hint.

The lesson here isn’t only about markets, but also about marketing—in particular, what’s called backtesting, a statistical dirty trick that’s central to Wall Street’s marketing playbook. And we can use the Dow, which this year has been drastically underperforming its younger cousin, the S&P 500, to help explain how the pros try to pull the wool over your eyes. Consider the way the indexes are constructed.

The Dow is price-weighted: The higher a company’s share price, the more it contributes. Stocks in the S&P 500, by contrast, are weighted by their total float-adjusted market value: share price multiplied by the number of shares that trade publicly. (The Dow, originally owned by Dow Jones, publisher of The Wall Street Journal, is now owned by S&P Dow Jones Indices, but two Journal editors sit on the index committee.) So Boeing, for instance, is 2.9% of the Dow.

That puts it barely behind Apple at 3.3%—because Boeing’s $172 share price is close to Apple’s $190. That’s why Apple doesn’t have a huge impact on the Dow. But Apple’s adjusted market value, $2.76 trillion, is 28 times greater than Boeing’s $98 billion.

This makes it far more meaningful to the S&P 500. Add up the share prices of the Dow’s 30 stocks, and you get something like $5,850. A new stock at $1,000 a share would constitute 17% of the basket—single-handedly unbalancing the entire benchmark.