The Dow Jones Industrial Average, which most people simply refer to as “The Dow” as if it were a personal friend (not to be confused with The Donald), is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq exchange. It is named for Charles Dow and Edward Jones, who created the original version back in 1896. Dow was editor and a co-founder of the Wall Street Journal; Jones worked for Dow as a statistician.
Keep the number 30 in mind when you consider how many stocks are out there today. The number of publicly listed U.S. stocks peaked at a record 7,562, during major league baseball home run king Mark McGwire’s record-setting summer of 1998, according to Wilshire, whose Wilshire 5000 Total Market Index is designed to replicate the entire U.S. Stock Market. (I guess 5,000 is close enough to 3,812, which is the total number of publicly traded U.S. stocks today).
But that’s small potatoes compared to the global picture: 46,678 publicly traded stocks, not counting investment funds.
Something else to keep in mind when you’re thinking about the significance of the Dow: Exchange-traded funds (ETFs) have quickly assumed a prominent place on the U.S. investment landscape. And unlike open-ended mutual funds, ETFs are stocks, and trade on the exchanges just like the rest. In late 2014, more than $2 trillion in net assets were held in 1,400 ETFs, up from a single offering in 1993, and fewer than 100 in 2002.
Still, traditional mutual funds still dwarf ETFs in market capitalization. According to the Investment Company Institute, there are nearly $16 trillion of assets owned across about 8,000 mutual funds.
Back to the Dow. Like other big indexes that are typically weighted by market capitalization, it is “price weighted,” which means the higher-priced stocks have a bigger weight in the index.
Here are the top ten most highly weighted Dow stocks:
- Goldman Sachs: 7.85%
- 3M: 6.15%
- IBM: 5.81%
- UnitedHealthcare: 5.67%
- Boeing: 5.39%
- Home Depot: 4.63%
- McDonald’s: 4.27%
- Travelers: 4.06%
- Chevron: 4.00%
- Johnson & Johnson: 3.99%
And here’s a current sector breakdown of the Dow:
- Financials: 20.13%
- Industrials: 19.92%
- Consumer Services: 14.98%
- Technology: 14.24%
- Health Care: 13.00%
- Oil & Gas: 7.12%
- Consumer Goods: 6.19%
- Basic Materials: 2.64%
- Telecommunications: 1.79%
So what’s the problem?
In short, market distortion. Financial stocks are up around 20% since the election, and that would mean it added 4% to your portfolio if you had just financials. The concept that an index composed of only 30 stocks is indicative of all things going on in the market is just not realistic. If you want to follow indexes, clearly the S&P 500 is closer, but it only measures… 500 stocks, naturally, and that doesn’t include such big market factors as ETFs.
But considering the way the Dow had to be calculated manually back in 1896, it’s easy to understand why Dow and Jones decided to stop at 30 stocks. They would have fainted at the suggestion of including 500, let alone thousands of them.
At Beacon we use a combined weighted index as a benchmark against your portfolios. That index is weighted by a balance of positions in big, medium, and small stocks as well as by industry. In addition, it has foreign and emerging markets factored in.
Regardless of our allocation, we always compare our portfolio to the weighted index to gauge our performance. But performance relative to even the best index can become a big distraction, at least in the short run. The most important consideration when evaluating a portfolio is whether its growth rate is keeping you on track to meet your financial goals.
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