Earlier this year, the Dow Jones Industrial Average (DJIA) closed above 40,000 points for the first time.1 This milestone was featured across news channels and websites, characterized as good news for the country.
CNN financial reporter Allison Morrow commented that for most people it was a comforting whole number which meant that the stock market was doing well, which in turn meant that the economy was doing well.2
However, Morrow went on to explain that the DJIA isn’t particularly relevant for most investors. “The Dow Jones Industrial Average, is, at best, an imperfect barometer of stock market activity among a narrow band of very large US companies. It’s clunky, and too limited in scope for any Wall Street pros to pay serious attention to it.”
That’s because of the somewhat arbitrary way the Dow is measured.
It’s an index that tracks the share value of 30 large US companies, prominent businesses like Amazon, McDonald’s, and Walt Disney. However, instead of ranking these companies by market capitalization (their total value), the index ranks them by share price. This results in a company like Goldman Sachs (a Wall Street bank with very little consumer facing business, valued around $125 billion) being deemed more important than Apple (about a billion customers, valued near $3 trillion).
To calculate the Dow average, you simply add up the price of one share of each of the 30 listed companies, and then divide by the “Dow divisor.” This is a constant that helps account for fluctuations in the market.
More broad measures of how the US stock market is performing overall would include the S&P 500 index or the even broader Russell 3000 – tracking 100 times the number of stocks in the DJIA and about 98% of US equity market cap.
One reason the Dow continues to be cited is that it’s been around for so long. Created in the 1890s, it’s the index that tells the story of the 1929 crash and market upheaval of WWII. The S&P 500 wasn’t created until 1957.
Morrow writes, “Despite its flaws, the Dow is a strong brand that’s been embedded in the American psyche.”
Of course, the prudent investor knows that no index—even one more accurate than the Dow—can truly measure his or her prosperity. First, an index doesn’t accurately reflect the exact makeup of an individually tailored portfolio. Second, even an exact valuation of an investment account is what an investor could expect to get if they liquidated everything to cash at that moment in time. This is something they certainly won’t be doing if their planned retirement date is in the future.
So, when you inevitably hear that the Dow is either up or down on a particular day, just remember that it’s not a reason to be overly excited or worried. It’s just a metric that’s so familiar, the financial media can’t resist reporting it.
If you ever have any questions about your investments or retirement plans, please feel free to give me a call at 801-545-0696.
Regards,
Mark Lund
Stonecreek Wealth Advisors, Inc.
11576 S State Street, Bldg. 1002
Draper, UT 84020
Sources:
1. http://go.pardot.com/e/91522/00-1st-time-story-id-110305831/95jnf1/2448291171/h/oz0SnFtfDHaLTupL-t0i01aoRFMqerhzh4pJ-8k9Omo
2. http://go.pardot.com/e/91522/00-history-nightcap-index-html/95jnf4/2448291171/h/oz0SnFtfDHaLTupL-t0i01aoRFMqerhzh4pJ-8k9Omo
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