Have you heard about the huge change in the Dow Jones Industrial Index? They are revamping the index big time. And it’s going to have a huge impact on investors – although probably not in a way most people expect.
What is the Dow Jones Industrial Index?
The Dow Jones Industrial or Dow is one of many stock market indexes. It was created by a chap named Charles Dow. Charlie first published the index back in 1896. The index is made up of 30 stocks that represent large publicly traded U.S. companies. Mr. Dow figured that if you followed what happened to the stocks in his list, you’d know what was going on in the market in general.
The Dow is calculated by adding up the value of one share of each of the 30 companies and dividing it by a divisor which changes from time to time. Charles was on to something. Investors do indeed watch how the Dow changes from day to day, month to month and year to year to gauge the overall health of the stock market.
Why is the Dow important?
Some people think that the Dow isn’t that important anymore. Compared to other broader indexes, the Dow Jones Industrial Average is antiquated they argue. It only measures the performance of 30 stocks compared to 500 for the S&P 500 for example. Also, the Dow Index uses a simplistic formula to calculate the values and doesn’t really tell you much. It is price-weighted rather than market-cap weighted. That means smaller companies with high stock prices have more impact on the index than lower priced stocks from much larger companies.
These are good points. And the Dow Jones Industrial Index’s influence might indeed be waning. But it’s still a widely followed number and therefore important to you if you are an investor. Many mutual funds still peg their performance to the Dow.
What are these big changes?
The Dow index is owned by the S&P Dow Jones Index Indices. The committee that oversees the index decided to remove Bank of America, Alcoa and Hewlett-Packard from the list of 30 and put Nike, Goldman Sachs and Visa in their place. These changes will take place at start of business September 23, 2013.
Why you should care.
There are two reasons why these moves are noteworthy.
1. Because Visa and Sachs are soon to be included in the Dow Jones Industrial Average, the index tilts more towards financial services. That isn’t necessarily a terrible development. But it means the Dow isn’t as broad a measurement as it could be. Companies like Google and Apple could have been added to put a greater emphasis on technology but that didn’t happen. Missed opportunity.
2. The very fact that the committee makes changes the component stocks from time to time is critical. This is something that most people forget about but it’s a game changer. Why?
Because when the committee changes the stocks that make up an index it skews its performance. If one of the companies – or in this case 3 companies – isn’t looking that great, the index can boost its performance by swapping them out for better prospects.
As an investor, you might do the same thing and that’s fine. There is nothing wrong with dumping the dogs and jumping on the screamers. But when people track their investments against the index and the index changes dramatically, it makes it more difficult to really know how you are doing compared to the “market as a whole”. Since the committee changes the stock makeup of the index, there really isn’t a way to know what the “market as a whole” is doing.
Keep in mind that ALL indexes make changes to their list as they see fit. And if I want my investments to keep up with the DJIA now, I will have to shift my holdings accordingly – and possibly take on more risk.
I’ve never been a huge fan of measuring “investment success” by how my account grows compared to the DJIA or S&P500. Now that you understand how the index owners change the index from time to time you can understand why. Why allow someone else to decide how much risk I should take in my portfolio?
A better, more accurate, more useful way to measure your investment success is to track your investment performance against your financial objectives and the amount of risk you are willing to take. If you are on track financially, what difference does it make if you are beating an index or not? The danger of blindly following an index is that it just might lead you into taking on more risk than you otherwise should.
How do you feel about the changes in the DJIA? Could care less? Am I getting all worked up for nothing or does it boil your tea as well?