At the end of last year, it seemed almost every day the Dow set a new all-time record. The Dow is likely to reach the 20,000 threshold in the weeks to come (if it hasn’t happened already). But is this important and what does it portend for your financial future?
The Dow, short for the Dow Jones Industrial Average, is the most followed financial number regarding the US stock markets. Whether you tune into NPR or Fox News, the media all seem to agree at least on one thing: the Dow is the most important measure of the performance of the US stock market. Given its prominence, it’s natural to assume that if the Dow is up that means the stock market did well, and if it falls that it did poorly.
The truth is that what we call the Dow is a 19th century relic that has arguable relevance to our financial lives. Have you been ignoring news of Dow 20,000? That may be the best approach. Here’s why.
You are almost certainly not invested in the Dow. Take a look at your latest retirement plan statement. Are you invested in the Dow? After all a target retirement fund invests in hundreds if not thousands of individual stocks. You may have a total stock market or S&P 500 fund in your investment mix. Those funds certainly hold stocks that are included in the Dow, but the Dow only includes 30 stocks. Yes the most widely followed stock index in the world is derived the stock prices of only 30 US companies.
The way the Dow is computed defies logic. The Dow is one of the few indices that is computed as a price-weighted index. I know this point sounds boring and arcane, but stay with me here. The higher the price that a given stock has, than the more weight it has in the Dow. Apple is the largest public company in the US by market capitalization, which is the value of the company as set by the stock market.
Today the market values Apple as a $640 billion company with a stock price of $120. Another Dow component company, Goldman Sachs, has a price of $234. Because it has fewer outstanding shares than Apple, even though Goldman’s price is higher, the company is valued at $90 billion. Because its price is higher, Goldman has roughly twice the impact on the Dow than Apple does. Perhaps even more absurd is 3M having a weight almost six times that of GE in the Dow, even though GE is worth twice as much.
The Dow includes very few companies. More than 50 percent of the Dow index is made up of ten stocks: Goldman, 3M, IBM, UnitedHealth Group, Boeing, Home Depot, McDonalds, Apple, Travelers, and Chevron. You shouldn’t use the performance of ten stocks as a proxy for the US stock market. At one point last month Goldman was responsible by itself for a 320 point increase in the Dow in the post-election rally.
There is much more than US large company stocks. Most of us are not invested exclusively in US large company stocks. A diversified portfolio should be invested in most cases from 20 to 50 percent in bonds. In contrast with the surging Dow, bonds had a subpar quarter to end the year as market watchers concluded that we were likely to see interest rate increases in the years to come. Intermediate term bonds were down 2.5 percent for the quarter according to Morningstar while long government bonds lost 11.8 percent. Also, foreign large companies declined 2.2 percent. So the many blended target date funds that include these categories were actually down for the quarter. This can be hard to hear after reading weeks of headlines of a buoyant Dow.
What should you do? Other than wishing that Dow weren’t publicized so widely, the best approach is to not react when the Dow soars and when it declines. Your portfolio is much more than the Dow, and for the most part that’s a good thing.