And the crowd goes wild…
On January 25, 2017 the Dow Jones Industrial Average (DJIA) broke new ground, closing above 20,000 for the first time. It’s all over the news, and this piece of history is getting plenty of traction.
It’s easy to see why people would get worked up over this. The bull market following the 2008 recession keeps on trucking and every new high is viewed with bated breath. Is the market overvalued? Will we see a correction?
Here’s the thing though: the Dow Jones doesn’t matter.
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That’s right. It’s actually a terrible economic indicator.
First off, what is the Dow exactly? It’s a stock market index consisting of just 30 American companies. They take the sum of the share price of each of these thirty companies and compute an average based off a number called the Dow Divisor. That’s the Dow Jones Industrial Average.
Some of the companies included in the index are: American Express, Boeing, General Electric, JPMorgan Chase and The Home Depot.
Part of the problem here, is that you can’t accurately judge the health of the overall U.S. economy on the back of 30 companies. You won’t find Google, Facebook or Amazon in the DJIA.
Secondly, the Dow doesn’t compute their average in a way that makes any sense.
Imagine you own a single share of Alphabet, Google’s parent company. That will set you back $850. Your friend, meanwhile, owns ten shares of Motorola. At $85 a share, you and your friend have both invested $850, but the Dow gives greater weight to the single share of Alphabet, than the ten shares of Motorola.
Imagine that single share of Alphabet increases by 10% while your friend experiences a 10% drop in his shares. If the market consisted of just the two of you, the overall effect would be neutral. You gain 10% and he loses 10%. The Dow, due to way it is calculated, would say there was an overall gain in the market.
It simply gives too much weight to higher-priced stocks. As a result, companies like Goldman Sachs and IBM have an outsized influence on the movement of the entire average.
Finally, the index is always changing. Since its inception in 1896, the index has changed 51 times. So if you want to look at the Dow on a historical basis, you have to know that you’re not looking at the same companies over time. In fact, when the Dow first came into being, it consisted of just 12 industrial stocks (hence the name). Today the index has little to do with traditional heavy industry.
Look, if you want a good market indicator, just go with the S&P 500.
At any rate, here we are. The Dow is at 20,000, likely because of positive expectations in regards to what President Trump is going to do to help boost the economy.
In fact, the S&P 500 also hit new-highs, in part due to bullish sentiment in sectors directly affected by the President’s first executive actions. Trump promised to boost manufacturing and announced the go-ahead of two pipelines so stay sharp on those areas.
So, remember the Dow doesn’t really matter. It’s just a nice, round number that the press can talk about. Instead, focus on your portfolio. There’s going to be a lot of talk about where the market is because of how long this bull market has lasted but as an individual investor, you still want to be making the best decisions for your investments. The rest is probably just noise.