The whole theory of share trading based on price action is about analysing the aggregate behaviour of the crowd as expressed in a chart which is the Dow Jones in the case of the US share market, and the All Ordinaries here in Australia.
Whenever the Dow Jones stumbles, the Australian All Ords are likely to follow, and whenever the Dow Jones jumps, so does the All Ords. And yet the two are as different as chalk and cheese: the Dow Jones is a price-weighted index of the top companies by share price whereas our All Ordinaries is a market-cap weighted index which means companies exert influence on our index based on their market value, not their share price.
The table above shows the top six Dow components by share price. Remember, these shares influence the daily fluctuations in the market more than the other by virtue of their high share price. Yet, as you can see, the companies with the highest share price are not the same as the companies with the largest market value.
The share price is a function of the number of shares outstanding and the current market value. But why should a high-priced share have more influence over a low-priced share, even if a lower-priced share is for a company with a large market value? It doesn't make much sense.
Exxon Mobil is the largest Dow component by market value, at $410 billion. But it's only the sixth-largest in terms of share price. IBM, a company half its size by market cap, exercises more influence over the Dow's daily changes.
The important point is that price-weighted indexes overstate the importance and power of certain companies. For example, IBM did $106 billion in revenue last year. That's not bad. But Exxon Mobil did $486 billion in revenue. You'd think Exxon would be a far more important component to index value.
What possible value is there in an index that weights stocks based on share price? The answer is: none! The Dow Jones Industrials Index communicates almost zero useful knowledge about the value of the securities in the index.
In Australia, companies exert influence on the index based on their market value, not their share price which produces a more accurate gauge of the direction of the market. It means companies like BHP, Rio Tinto, and the Big Four banks exert a lot of influence over the direction of "the market".
However, the issue of survivorship bias is usually brushed under the rug when discussing index returns over time. Survivorship bias is the idea that indices' historical returns are overstated because companies that fail drop out of the index and new ones are added. In other words, the index only ever measures the businesses that succeed over time.
That measurement - an indices' performance over many decades - is probably not an accurate reflection of what an active individual investor would get in his investment lifetime. He'd own the winners and the loser. And he'd see that historical index performance statistics probably overstate the historical performance of stocks as an asset class.
