The Dow Jones Closed Above 20000 and the Reasons Why You Shouldn’t Care

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The Dow Jones Industrial Average (DJIA or the “Dow”) closed above 20000 for the first time on January 25, 2016. It was a page one news story in the Wall Street Journal and many other publications. The S&P 500 Index and the NASDAQ set records the same day but did not receive as much attention.
 
According to the Wall Street Journal, “Applause, whoops and cheers erupted on the floor of the New York Stock exchange.” So it must be important. Right?
 
Wrong.
Here are some reasons why Dow 20000 doesn’t matter:
 
The Dow is a very narrow index
The DJIA was designed in 1896. It had to be simple to calculate because there were no calculators, computers, etc.
 
To keep the index simple, there were only 12 stocks (today there are only thirty) and the index was “price weighted”. Price weighted means that the Dow was calculated by adding the prices of the 12 stocks and then dividing by 12. (Source: Investopedia.com).
 
Today, it is calculate by adding up the price of 30 stocks and dividing by the Dow’s “divisor.” The Wall Street Journal states that the divisor “is a figure that adjusts for the effect of stock splits and other changes over time… (Otherwise, for example, a stock’s 2-for-1 split would suddenly throw off the Dow.). The divisor… is 0.14602128057775.” The divisor changes over time.
 
Price weighting is a poor way to construct an index. It means a $20 stock has twice as much influence on results as a $10 stock, even if there are twice as many shares outstanding for the $10 stock. As a result, there is no consistent relationship between the size of a DJIA component and its effect on the index.
 
For instance: "The Dow’s strange focus on share price gives far more weight to [Goldman Sachs Group] than the bank’s market value deserves. At $236.59 a share, it is the most expensive stock in the average, meaning it has twice as much of an effect on the average as Apple Inc., which has a market capitalization more than six times that of Goldman.” (Source: "We’re Already at Dow 30000, You Just Don’t Know It," Wall Street Journal, January 25, 2017)
 
A thousand point change isn’t what it used to be
The first 1000 point Dow increase was January 1987 when it hit 2002. That was a 100% increase from 1000. Each subsequent 1000-point increase represents a smaller percentage change. Going from 19000 to 20000 was only a 5.3% increase.
 
The Dow is actively managed
The Dow is not what I would call a naturally occurring index. The stocks included are chosen by a committee and change over time. Some of the decision makers are editors at the Wall Street Journal. Does being a Wall Street Journal editor make someone an expert stock picker?
 
Compare that to the Russell Indexes. The Russell 3000 index is naturally occurring. It is the 3000 largest US companies by market value (number of shares x price per share). Once a year it is changed to reflect changes in company value. No active management there.
 
It does not include dividends
Dividends paid by the 30 DJIA companies do not affect the index returns but they greatly increase investors’ returns. This is true of most indexes.
 
Investors in index mutual funds or Exchange Traded Funds do benefit from dividends. As a result, Index Funds usually have a higher rate of return than the return for the Indexes that they are based upon.
 
Over the last 15 years, reinvested dividends would have added 57% to the return of a DJIA index fund and 47% to an S&P 500 Index Fund.
 
The allocation of the DJIA probably doesn’t match your portfolio
Most investors are invested in stocks and bonds. The DJIA is all stocks. It contains only large-cap stocks, mainly value and blend.
 
When stocks are doing well, the DJIA will outperform portfolios containing both stocks and bonds. When stocks are declining, the DIA will probably underperform.
 
What goes up will come down
Past performance is no guarantee of future performance and Dow 20000 is not a reason to increase or decrease your investment in stocks. Investors need to be aware that the Dow and other stock market indexes increase and decrease over time.
 
The DJIA is overdue for a 20% or greater decline. On average, historically, 20%+ Dow declines occurred every 3.5 years. As of today, the Dow haven’t had decline of that size in almost 8 years!
An "embarrassing anachronism"
 
According to Wall Street Journal columnist James Mackintosh, the Dow “is an embarrassing anachronism, abandoned by professionals and beloved only by a media that mostly knows no better. It needs to be updated or, better, replaced…It is not a good measure of the broad market—indeed it is not even designed to be. It is not a good guide to investing. It is not calculated in a sensible way. And it isn’t even right…Correct for mistakes dating from the days of paper and slide rule, and the Dow in fact passed 30000 for the first time last month.”
 
For investors
What is important for investors is the return on their investments over time, volatility, taxes on investments, inflation, how closely the allocation of their portfolios match their actual risk tolerance, time horizon and need for income from their investments. The Dow hitting 20000 doesn’t affect any of these.
 
It is not “Don’t worry, be happy.” Nor is it “Worry, don’t be happy.”
 
It is more like “Keep calm, carry on and don’t pay attention to Dow 20000.”
 
Notes:
 
This is for educational purposes only. To learn more about the topics mentioned and if they are suitable for you, consult an appropriate professional. Tax laws can change at any time.
 
Any information provided in this presentation has been prepared from sources believed to be reliable, but is not guaranteed and is not a complete summary or statement of all available data necessary for making an investment decision. Any information provided is for information purposes only and does not constitute a recommendation.
 
Keep in mind that:
  • Past performance is no guarantee of future performance;
  • Investments involve the risk of loss of principal and earnings;
  • ETFs, mutual funds, money market funds, etc. are not guaranteed by the US Government, the FDIC, a bank or anyone else.
  • “Average annual return” evens out variations in the actual year-to-year returns.
  • ETFs, mutual funds and individual stocks and bonds fluctuate in value and there will always be times when they lose value.
  • None of the information provided is necessarily relevant to anyone’s personal situation. Circumstances differ among individuals and they should not assume that these generalizations or information apply to them.
  • Investments mentioned may not be suitable for all investors.