What is the a stock index and Should You Care?

Every night on the morning news, you will hear commentators talking about the US Stock Index (Deutscher Aktienindex), either by its full name or one of its shorter nicknames—the DJI30 or the Dow Jones. Somehow as we are listening to the talking heads, we all seem to know that we are supposed to be happy when we hear that the Dow Jones is rising and that we are supposed to be sad when we hear that the Dow is falling, but why? What on earth is the Dow Jones, and why should we care—or should we?

Let’s start by looking at what the Dow Jones is. Once you’ve got a good handle on what the index is, what it measures and how it’s calculated, we will answer the question of whether or not the Dow is something you should care about as an individual investor or trader.


What is the Dow Jones index

The Dow Jones is a price-weighted index composed of 30 of the most widely traded large-cap german stocks—which are supposed to represent the broader market as a whole. In theory, the movements of these 30 stocks should be representative of the overall market. Oftentimes, investors prefer to use indices when tracking the market to give them a narrower view of what is happening in the overall market. You have most likely also heard of some of the other major stock indexes like the S&P 500, Dow Jones Industrial Average Index or FTSE100. Each one of these indices provides unique information for investors.

The Dow Jones index is calculated starting with 30 Dec 1987—from a base value of 1,000 points. At that time, the index only contained 12 stocks, and all of them represented large, industrial companies. The thought behind this index was that these large, industrial companies should be an excellent barometer for the U.S. economy because it was so closely tied to the growth of large industries.

The number of stocks comprised in the Dow has since grown to 30 as the market has evolved and diversified. And while many of the stocks within the Dow no longer represent industrial companies, the name “Industrial Average” remains.

A list of the current Dow Jones companies, as of the quarterly review effective on 20 March 2017


Calculating the Dow Jones

The Dow Jones Industrial Average was originally calculated as a simple average. All you had to do to determine the value of the index was add up the price of each of the stocks in the index and divide that sum by the number of stocks in the index. For instance, when the index was first calculated, Charles Dow added up the price of each of the stocks in the index for a sum of $491.28, divided that number by 12 and got the first ever reading of 40.94 for the Dow Jones Industrial Average ($491.28 ÷ 12 = 40.94).

While the basic concept is still the same, Dow Jones & Company—the company responsible for maintaining the index—has had to make some adjustments to compensate for the increased number of stocks in the index, for additions to and subtractions from the index (as companies emerge and decline) and for stock splits, spinoffs and other corporate actions. Today, instead of simply dividing the sum of the stock prices by a divisor equal to the number of stocks in the index (30), Dow Jones & Company uses a modified divisor of 0.122834016 [as of the time of this writing…click here for current divisor]. For instance, the sum of the stock prices listed above is $1,432.07. If you divide that number by the current divisor employed by Dow Jones & Company, you get a current value for the Dow of 11,658.58 ($1,432.07 ÷ 0.122834016 = 11,658.58).

For those of you hard core math folks, you can find the formula for calculating a divisor change here.

What is Price Weighting?

As I mentioned earlier, the Dow Jones Industrial Average is a price-weighted index. A price-weighted index is an index where the stocks with the highest prices tend to have the largest impact on the value of the index. Looking at the list of 30 stocks above, you can see that International Business Machines Corp. (IBM) is currently the most expensive stock in the Dow, at $126.36, and that General Motors Corp. (GM) is currently the least expensive stock in the Dow, at $11.18. Now imagine that each stock moves up 10 percent. If IBM moves up 10 percent, it will at $12.64 to the numerator (the sum of all of the stock prices) in the equation above, while if GM moves up 10 percent, it will only add $1.12 to the numerator in the equation above. Even though each stock increases in value by 10 percent, IBM will have more than 10 times the impact on the value of the Dow.

We all know that newscasters everywhere love the Dow Jones Industrial Average. It’s so easy to use in the middle of a news cast, and it seems to give a succinct overview of how the market is doing. “The market fell today as the Dow Jones sank 428 points, a 3.4 percent drop…its largest in more than a month.” Of course, news like that makes viewers squirm in their easy chairs because nobody wants to hear about the market falling. But should we, as investors, really care what the Dow Jones Industrial Average is doing? We’are going to answer this question the easy (and correct) way and say, “Yes and no.”

In this section, we will address the “Yes” portion of our response, and in the next section, we will address the “No” portion of my response.

Why You Should Care About the Dow

Most investors should care about what is happening to the Dow Jones Industrial Average—not because it tells you what is happening to the overall market but because you are most likely invested in companies represented by the Dow. Now, when I say represented by, I am not limiting the discussion to those 30 stocks that are officially tracked by the Dow. Instead, I am referring to large-cap stocks in general.

The Dow Jones is comprised of 30 large-cap stocks. A large-cap stock is a stock with a market-capitalization rate, or market cap, of more than $5 to $10 billion. As you can see from the table below, many of the stocks in the Dow have market caps well over $100 billion—with ExxonMobil Corp. having the largest market cap by far at $400.3 billion. Only one of the stocks in the Dow, General Motors Corp. has a market cap of less than $10 billion ($6.33 billion).

Large-cap stocks are incredibly important to retail investors because most of us have a significant portion of our stock holdings tied up in large-cap stock investments. If you are invested in or are receiving benefits from any of the following, you have exposure to large-cap stocks:
– Mutual funds or ETFs that tracks the Dow Jones Industrial Average
– ETFs or Mutual funds that tracks the S&P 500
– Mutual funds or ETFs that tracks the S&P 100
– Target-date mutual funds
– Large-cap growth funds
– Large-cap value funds
– Company pensions
– State-funded pensions

Investment advisors and pensions like large-cap stocks because they are relatively stable, and they are easier to move large amounts of money in to and out of. Imagine being a fund manager and looking for someplace to move $100 million. It is much easier to move that money into a stock with a $100 billion market cap than it is to try and put it into a stock with a $1 billion market cap.
So, should you care about the Dow Jones Industrial Average? Yes…at least a little. Watching what is happening to the Dow Jones Industrial Average can help you keep track of what is happening to many of the large-cap stocks in your portfolio. And since those large-cap stocks probably make up a significant amount of your portfolio, knowing what is happening to them is always a good thing.

The Dow Jones Industrial Average is an interesting part of the financial landscape. It is steeped in history, and we discussed why so many investors are interested in it, but we still haven’t discussed the reasons you shouldn’t care about the Dow Jones Industrial Average. Well, we’re about to remedy that right now.

The Question:

We are told if the Dow is going up, it is a sign that the market is doing well. Conversely, if the Dow is going down, it is a sign that the market is not doing so well. But is that really the case?
To answer our question, we need to look at the stocks that comprise the Dow and how the Dow is calculated. We’ll start by looking at the stocks that comprise the Dow. If you’ve been reading the articles in this series on the Dow Jones Industrial Average, you’ve seen this list before, but it will useful for this to take a second look. 

As we mentioned in the previous section, each of these stocks is a large-cap stock—which means the Dow Jones Industrial Average is a great indicator for how well most of the large-cap stocks in the market are doing. However, large-cap stocks are the minority in the stock market. Mid-cap, small-cap and micro-cap stocks make up the majority of listed stocks, and their performance tends to vary from the performance of large-cap stocks.

You don’t have to look any farther than the comparison between the Dow Jones Industrial Average (^DJI) and the Dow Jones U.S. Small-Cap Index (^DJUSS) to see that stocks with different market capitalization rates often vary in their performance. You can see in the chart below that duirng the past five years, the Dow Jones U.S. Small-Cap Index (blue line) has increased by nearly 60 percent while the Dow Jones Industrial Average (red line) has only increased by 20 percent.

Had you only been watching the Dow Jones Industrial Average during the past five years, you might have thought growth in the stock market has been rather sluggish. But if you broaden your perspective, you can see that there are segments of the stock market that have been growing quite nicely.

Plus, the Dow Jones Industrial Average is a price-weighted index. This means that the stocks in the Dow Jones 30 with the highest prices tend to have a disproportionate effect on the value of the index. For instance, International Business Machines Corp. (IBM) will most likely have a larger effect on the value of the Dow than General Motors Corp. will because if each stock moves up 10 percent, IBM will add $12.64 to the number used to calculate the Dow, while GM will only add $1.12. So even though each stock increases in value by 10 percent, IBM will have more than 10 times the impact on the value of the Dow. This tells us that while the 30 stocks in the Dow Jones Industrial average represent large-cap stocks, there is an even smaller portion of those 30 stocks that actually drive the majority of the movement in the Dow.

The Answer:
If you invest in stocks other than large-cap stocks, you do not need to worry about the value fluctuations in the Dow Jones Industrial Average. Instead, you should focus on other indices when monitoring how the stocks you are invested in are performing.

How to Invest in Stock Indexes

For example, consider the case of the polish stock market investor. Even if your stock index portfolio has done well in Polish currency (PLN) terms, over the past years, the picture is less rosy against other major currencies and commodities, like USD or USD denominated commodities. Because we all use imported products, this means your purchasing power and wealth are melting away if your stocks indexes are in a declining currency like the PLN. For example, anyone whose stock indexes are too concentrated in PLN has paid the penalty countless times whether they realize it or not.

To protect yourself, you need as much of your stocks as possible to be denominated in the currencies that are likely to hold their real value or appreciate in the long run and lift your portfolio along with them. Because a good stock market investment denominated into a wrong currency may become a bad stock index investment and vice-versa.

Investing in the Stock indexes in your country short version: first you identify the currencies you want represented in your portfolio, then you allocate a percentage of your portfolio to each one, and finally, you choose the individual stocks (shares or stock indices) that provide that given percentage exposure.

That’s the basic idea. Obviously, you’ll need to weigh the quality of the stocks you buy or indices versus that of the currency.

Here’s the more detailed version of the steps involved to start playing the stock market the right way to profit twice.  

Step 1 - Identify the right currencies 

  • Study currency market weekly or monthly charts or representative currency indexes for your projected holding period. If you’re planning to buy and hold stocks for months to years, you want to see trends over the prior few years. For support, read also what is forex and how does it work.
  • Identify the currencies with the healthiest uptrends over that period. For support, read how to invest in forex for income.
  • Check that the underlying national economic fundamentals support that trend with relatively good growth, or at least consistently low ratios of debt to the gross domestic product (GDP) and culture of fiscal discipline, not growing budget and trade deficits. For support, read also how to use the forexfactory.com calendar and how to read the news.


Step 2 - Allocate a percentage of your portfolio to each currency 

Allocate percentages of your portfolio for income-generating instruments denominated in or tied to those currencies that are more likely to appreciate in the long run.  

Step 3 - Choose the individual shares that provide that given percentage exposure

Then shop around for specific assets you want that are denominated in or exposed to those currencies so that you have a set portion of your portfolio in both the right currencies and assets in those currencies. The research method is the same as for any shares and bonds buying, forex and commodities, and so on. The only difference is that in addition to your normal screening criteria, you screen by country or currency, either traditional shares listed on a stock exchange or indices and shares CFD (IF you prefer CFD trading, a more flexible alternative to traditional share dealing, but also riskier) that meet your investment criteria.\

Case Study - Applying Forex Trends to Stock Indexes

Imagine that three years ago a Polish investor (No. 1) decided to seek currency diversification for his portfolio beyond the Poland Stock Exchange, converted 100,000 PLN to USD, and invested the sum in a basket of US stocks that comprise the DOW JONES index, an index that tracks the American shares listed on the New York Stock Exchange. His friend, fellow Polish investor No. 2, took the same sum and invested it in a basket of Polish shares listed on the Warshaw Stock Exchange that comprise the WIG20 index (WIG components - eg. JWS shares, pro shares, ...).

Note: The following assumes that dividend stock prices of the United States and Poland move in the same direction as the primary national stock indexes just for the sake of comparison, and does not take into account gains from dividends, commissions or any other fees.

Obviously, we have a strong and overall very steady uptrend for the USDPLN course. Here are the numbers*:

  • USDPLN, 1 June 2014: 2.99
  • USDPLN, 1 June 2017: 3.70 Change: +0.71 Percent change: +23,74%

*(opening price in web.ambroker.com)

During the last 3 years, investor No. 1 gained almost 24% over investor No. 2 just on currency appreciation.

Of course, currency appreciation by itself isn’t necessarily enough. If you don’t have the right investments in a given currency, you still could lose.

Anyway, just looking at relative currency performances, the USD denominated assets looks like the best investment.

For example

Three years ago investor No. 1 converted 100,000 PLN to USD, then invested that in the S&P/DJIA composite index or a similar basket of stocks listed on NYSE:

  • 100,000 PLN into USD in mid 2014 became: $33,000
  • That $33,000 invested in stocks grew to be about ($33,000∗27% SP500 appreciation): $41.910
  • That $41.910 converted into PLN after 3 years ($41.910∗3.7 UsdPln rate): 155,067 PLN

Three years ago investor No. 2 invested 100,000 PLN in the WIG20 composite index or a similar basket of stocks listed on WSE:

  • That 100,000 PLN invested in the WIG20 in mid-2014 became about: 96,000 PLN
  • Difference 59,000 PLN

 

In sum, our sample investor No. 1 who went with US currency and bought stocks benefited from both currency and stock market trends for a gain of 55,000 PLN versus a $4,000 loss for No.2, who stuck with PLN currency and stocks.

 

 

Categories:  Investing