Inside an Index

The seasons are changing, but not much seems to be changing with stocks. Leaves are falling. Stocks prices are ascending. Another day, another new all-time high.  Even the first trading day of Q4 welcomed new highs, and the Dow Jones Industrial Average crossed 23,000 for the first time on October 18^th.  The media seems to set off fireworks each time we cross another “thousand” so it’s never hard to lose track, but is there really that much reason to celebrate?  It’s time for some back to basics on the Dow as we near the halfway point of the final quarter of 2017.

The Dow, short for the Dow Jones Industrial Average, is a stock benchmark that is over a century old. Charles Dow created the Dow back in 1896 to serve as a measure for the U.S. economy, and it originally included only 12 companies. The benchmark calculation was really simple... add the stock prices for those 12 companies and divide by 12. Makes sense for a benchmark labeled an "average," right?  Over the years the benchmark has accumulated more stocks, and it currently holds 30 of the largest companies in the U.S.

Initially, the Dow was made up of railroads, various manufacturers, and utilities.  Today, the Dow still represents some of the largest industrial companies, but it also represents a fair share of financials, cyclicals, healthcare, and some information technology, although not a lot. The Dow has certain nuances, or flaws, and the first I can point out is the method used to determine its holdings. Dow stocks are currently determined by a committee, and there really are no clear-cut rules or criteria for becoming a member holding. Holdings change based on market conditions and based on what I’ll call an “eye test,” for lack of a better term.  So there’s really not a whole lot to the Dow’s “composition methodology,” if you want to call it that.

Also important is the weighting methodology, which determines how much percentage share a stock gets in the index. Indexes like the S&P 500 and many other major benchmarks are built based on company size, or capitalization weighting ("cap weighting" for short). If an index is cap weighted, then the biggest companies make up the largest share of the index. The Dow is a price-weighted index, so the actual stock price plays a very large role in the composition. Currently, the Dow’s three largest holdings are Boeing (7.5% ), Goldman Sachs (7.1%), and 3M (6.9%), and all of their share prices trade in the $200's. Apple is currently the 7th largest holding, even though its cap weighting and revenues outsize the likes of Boeing and Goldman Sachs combined.  Apple’s revenue is more than twice as much as Boeing and seven times as much as 3M.  Go figure.

So where are Google, Amazon, and Facebook? They're not reported in the Dow. A Bloomberg article recently looked into Dow holdings and made a few interesting observations. First, we haven't seen a lot of big companies split their stock price. Stock splits are maybe old fashioned, and a higher share price is possibly some sort of accomplishment for these companies. It's great for them, but high stock prices don't make Google or Amazon easy additions to the Dow. Amazon's earnings reports are no stranger to being openly criticized, and stretched P/E multiples don't make it an easy add to the Dow. Also, Google has multiple share classes, which complicates matters. But maybe Facebook replaces a dusty old holding someday?

The Dow’s biggest problem is that a portfolio of 30 stocks is not as diversified as most investors should be.  Concentration can quickly create wealth, but the opposite is also true as well—it can quickly destroy wealth.  There have been single trading days where the Dow closed higher by over 5%, but there have also been days when it closed lower by more than 7%.  Many investors would be out of their comfort zone with down days like that.

The second biggest problem that I tend to come back to is the weighting method. Price weighting is a flawed method for a building an investment benchmark. Its fine when your top holding is up 70% for the year, which is where Boeing currently stands; that's actually great for Dow investors. But, what about when your smallest stock holding is up $1, and your largest stock holding is down $1? In percentage terms, your smaller holding has a larger numerical gain compared to the larger holding's loss, but your larger holding is your larger holding, so you suffer. Price weighting also creates situations where the top 10 holdings of the 30 holding benchmark make up nearly 55% of your portfolio. That's a lot of concentration to those 10 companies that became the top 10 based mainly on stock price!

There’s no question in my mind that it's amazing to see how far back the Dow has come since depths of the Financial Crisis, and even since the 2016 presidential election. Years like 2017, where stocks venture into uncharted territory, we often see a flurry of new all-time highs over the course of that year, and that's exciting. But when it comes down to the Dow relative to your finances, you have to draw a line between what's exciting and what is meaningful. For most investors, a meaningful investment strategy involves being prudently diversified across a lot more than 30 stocks. It requires a thoughtful approach to investment choices, regardless of stock price, stock splits, or stock share classes.

It probably sounds like I'm picking on the Dow, and I am… but I find that informed clients are often happier clients.  Ultimately, you should know that your investment strategy is driven by something a bit more advanced than a math exercise we learned in middle school. If you want a better idea of what your personal benchmark should be, just give us a call.  We’d be more than happy to help you better understand what stocks and the economy mean relative to your finances.