The Dow Jones Industrial Average (2006-10-09)

The Dow Jones Industrial Average

(2006-10-09) by David John Marotta

The Dow set a new all-time high last Tuesday. While most investors follow the numbers from the Dow Jones Industrial Average index, they are most likely invested in funds that mimic the S&P 500. However, neither index represents a diversified portfolio. Diversified investors often see positive market returns, even when these indexes are struggling. Understanding just how the Dow works allows savvy investors to see past this index when evaluating the performance of their investments.

The Dow is the oldest market index still in existence. It was created on May 26, 1896, by Charles Dow, co-founder of Dow Jones & Company and The Wall-Street Journal. In the original index, Charles Dow simply picked a dozen significant stocks which represented different industries, added their prices together, and divided by 12. Thus, the Dow was born, weighing in at the starting value of 40.94.

The fundamental method for computing the Dow hasn’t changed much in the last 110 years. The number of stocks in the Dow increased to 20 in 1916 and then to 30 in 1928. Today, the movement of the Dow represents the price changes of 30 significant stocks. Of the 30 stocks in the Dow today, only one was in the original 12—General Electric.

Sometimes, changes in the composition of the Dow adversely affect the index. At the end of 1999, the Dow changed four components at exactly the wrong time. It replaced Sears, Goodyear, Chevron, and Union Carbide with Microsoft, Intel, SBC Communications and Home Depot. As a result, the Dow did not grow with the bubble when Microsoft, Intel and SBC went up, but it did drop sharply as a result of the bear market correction.

The Dow struggles when used as an accurate financial barometer for a couple of reasons. It is comprised of a limited number of stocks, and the movement of each stock in the Dow does not affect the index equally.

For example, if a stock which usually trades for $10 per shares goes up by $1, it has the same affect as a $100 stock that goes up $1. Thus, the percentage movement of a stock which sells for $100 per share has ten times the effect on the index as the $10 stock. If the $100 stock splits and its share price drops to $50 per share, the Dow adjusts its multiplier to negate the effect of the split. But, future price movements of that stock will have only have half of the effect that they would have had before the split.

This computation is called a “price-weighted” average. If you followed my example, you can see how this method of computing an average might have been a good way of getting a handle on the markets in 1896, but it doesn’t make any sense in the 21st century.

From 40.94 in 1896, the Dow climbed to 381.17 on September 3, 1929. After that, the Dow declined all the way back to where it started, closing at 41.22 in 1932. The bear market lasted 18 years until the post-World War II boom began in 1949. Over the next 17 years after the war, the Dow increased from 150 to 995.

The next bear market, which spanned 1967 to 1982, saw the market go sideways as inflation ate up more of investors’ purchasing power every year. Everything from wage controls to price controls to the 70% top marginal tax rates doomed the efforts of small businesses to generate sustainable wealth.

In 1980, Reagan was elected. Reagan, with the help of Fed Chairman Paul Volcker, broke the back of inflation by tightening the money supply and by cutting the top marginal tax rate from 70% to 33%. Initially criticized as a tax cut for the rich, Reagan’s economic policy actually increased tax revenues by encouraging more Americans to take risks and to start businesses of their own. What followed was a renewed spirit of capitalism and a boom in small business growth, which then fueled a boom in the economy as a whole.

From 1982 through 1999, the Dow experienced phenomenal growth, closing at a high of 11,722.98 in January of 2000. This was the period when it seemed that the markets only went up, except for one year. The biggest percentage drop in the Dow during the last 50 years occurred on “Black Monday” October 19, 1987, when the Dow fell 22.6%. This 554.26 point drop turned out to be a great buying opportunity in the middle of a long-term rally. The biggest one-week drop came on September 17, 2001, when the stock markets re-opened after the 9/11 attacks. During that one week, the DJIA dropped 1369.7 points.

On Tuesday, October 3, 2006, the Dow closed at 11,727.34 breaking its previous high of 11,722.98 achieved on January 14, 2000. The S&P 500, however, is still 12% off its high and the NASDAQ is still a whopping 55% off its high – even after more than 6 years! If your portfolio has barely recovered, your portfolio probably isn’t well diversified. Now would be a good time to closely examine your portfolio. For a contrarian, when financial markets make the news headlines, it has historically been a good time to rebalance into overlooked and underloved investments.

Truly diversified investors are accustomed to experiencing positive returns even when indexes like the Dow and S&P 500 are struggling. Commentators in the mainstream new media may be going crazy over the new record high for the Dow, but if your portfolio has gone nowhere in the last six and a half years, maybe it is the right time to consider a more diversified approach. Diversified portfolios recouped their bear market losses much faster and gained their highs well before 2006.

If you not sure what annual return you are making on your investments, you want to consider a comprehensive portfolio analysis. While the Dow’s record-setting performance provides an upbeat financial news event, it only matters to your financial health when your portfolio is setting new highs. Make sure that you are measuring the progress made each year toward reaching your financial goals.

from http://www.emarotta.com/article.php?ID=199