Down 600 points one day, up 400 points the next, down another 500 points a day later, then up another 400 points the day after that — yes, the Dow Jones industrial average is back in the news. Charles Dow devised the index in 1896 to give investors a snapshot of the performance of big manufacturing stocks (and of the U.S. economy) each day. The Dow still has an antique feel to it, but as a metaphor for the stock market, it remains unsurpassed: endlessly cited, parsed, followed, predicted — and misunderstood.
1. The Dow is an index of very large industrial companies.
Not anymore. The Dow’s components change every few years to reflect the breadth of the U.S. economy and to drop troubled companies. The 30 companies it currently comprises include four financial firms, two giant retailers, one restaurant chain, five consumer-products makers, two telecommunications firms, three drug companies, five high-tech firms and an entertainment conglomerate. There are only five traditional manufacturers — Caterpillar, Alcoa, United Technologies, 3M and the highly diversified General Electric — plus a couple of energy companies.
Nor is the Dow a collection of the largest U.S. firms. Among those missing are Apple — which lately has been trading places with Exxon Mobil as the biggest company in America — and Google, which has a larger market capitalization (the number of shares outstanding multiplied by price) than Wal-Mart, a Dow component. While Apple had a market cap of $347 billion, as of Tuesday, Alcoa had a cap of just $13 billion.
Even stranger is how the Dow is calculated. Most indexes, including the Standard & Poor’s 500, are weighted by market cap: Bigger companies affect the index’s value more than smaller ones. But the Dow is weighted by stock price — an arbitrary figure that has little to do with size or value. Both McDonald’s (market cap: $89 billion) and Intel ($109 billion) are part of the Dow. But because McDonald’s trades at $86 a share, it has more than four times the impact on the Dow’s movements as Intel, which trades at $21. IBM is the Dow’s top dog, with a greater impact on the index than Alcoa, Bank of America, Cisco, Intel, Pfizer, AT&T, GE and Hewlett Packard combined.
2. Movements in the Dow are driven largely by corporate data such as earnings and revenue.
If only it were that simple. The market value of the Dow, like that of any individual stock, is determined by a consensus view of buyers and sellers, who guess the company’s value today by trying to forecast what it will earn in the future. Those projected profits are influenced by all sorts of things, including domestic politics and the federal budget. And for the blue-chip companies that inhabit the Dow, the overall performance of the U.S. economy may be most important of all.
In that sense, the losses and volatility of recent days can be viewed as a result of investors’ reassessments of America’s long-term growth prospects. Instead of the 3 to 3.5 percent growth rates that the economy has averaged since World War II, we are facing rates a full point lower, or worse, now and probably in the future. Of course, the government might take steps to boost growth — reforming the tax code, for instance, to encourage more investment; or changing immigration policy to attract smart, entrepreneurial foreigners; or seriously chopping wasteful spending. But for now, the markets seem to be adjusting expectations downward.
Of course, investors often get carried away by emotions. In the short term, prices can be influenced by buying or selling panics. But in the long term, stock prices tend to be an accurate reflection of a company’s value as a profit machine. It’s just that the long term can take a while.
3. It’s not easy for an individual investor to purchase the Dow as a whole.
That used to be true, but in recent years, the markets have undergone genuine democratization. It’s now relatively easy and cheap to buy sophisticated securities, such as baskets of diverse stocks or funds that move in the opposite direction of the overall market. If you like the Dow, your ticket is the SPDR Dow Jones Industrial Average Trust, an exchange-traded fund that you can buy and sell on the New York Stock Exchange as if it were an individual company. The fund, which goes by the nickname “Dow Diamonds” (DIA), trades at roughly 1 percent of the value of the Dow (in other words, you buy it for $110 a share when the Dow is at 11,000).
4. With just 30 stocks, the Dow is not a reasonable reflection of the broader market.
Surprisingly, the Dow is an awfully good barometer of the overall market. It closely tracks broader indexes, such as the S and P 500. Between its start on March 4, 1957, and Aug. 5, the S and P increased an average of 6.1 percent in price each year; over the same period, the Dow increased 5.9 percent annually. The Dow, because it is composed of larger, more established companies, tends to be a little less volatile than the broad market. For example, in 2008, when the S and P dropped 37 percent for the year, the Dow fell 34 percent; in 2009, when the S and P rose 23 percent, the Dow rose 19 percent.
5. Over the long run, investing in the Dow is all the average investor needs to do.
That might have been true 10 or 20 years ago, when the United States dominated the global economy. But today, investors need more diversification. The Dow is fine as the U.S. large-cap part of your stock portfolio, but you also need to own international stocks — especially from developing markets such as China, India and Brazil — and shares in smaller, faster-growing companies.
Most important, however, is that in these complicated times, when previously unthinkable events (say, a downgrade of U.S. Treasurys) can dramatically affect stock prices, investors need to protect themselves on the downside. The easiest way to do that is through a portfolio that is weighted more toward bonds — both government and corporate — than before. Bonds often go up in price when stocks go down, as they did on Monday, when the Dow lost 634 points. Since bonds offer lower returns, they may reduce your upside, but they cushion your downside.
And yes, I am the guy who co-authored a book called “Dow 36,000″ back in 1999. Do I still think it will eventually hit 36,000? Yes, but I don’t know when. In the meantime, invest in the Dow — but in bonds as well.
James K. Glassman, executive director of the George W. Bush Institute, wrote the Investing column for The Washington Post from 1993 to 2004. He is a columnist for Kiplinger’s Personal Finance and the author of “Safety Net: The Strategy for De-Risking Your Investments in a Time of Turbulence.”