Where were you on November 14, 1972? I don’t recall much, as I was only 4 years old, but I do have a memory of it. We had one black & white TV in our home that was always tuned to Walter Cronkite at 5:30 PM on the local CBS affiliate (it was one of only four choices if you counted PBS).
My earliest memories are of watching Apollo rocket launches and splashdowns on that rabbit eared tube. While I don’t remember exactly why I was paying such close attention on this day, I suspect that my mom had mentioned that they may show the astronauts or the rocket pad at Cape Kennedy, as the Apollo 17 mission was scheduled around that time. While this tactic may have kept me out of her hair while she was cooking dinner, it also led to me to asking questions. A LOT of questions.
“What is Vietnam,” I would ask?
“A country,” would be the reply.
“What is a Watergate?”
But sometimes, the answer would just be, “Ask your father when he gets home.”
On this day, Mr. Cronkite had led the news with a headline that announced that the Dow Jones Industrial Average had just exceeded 1,000 points for the first time in history.
“Mom, what is the Dow Jones Average?”
“It is where you can invest in companies,” she said.
“What does it mean to be at 1,000 points?’
“Ask your father.”
I’m sure I did, but I don’t remember his answer.
I was just as clueless as a freshman in college in 1987 when the headlines read that the Dow had exceeded 2,000 points, but I knew that the second thousand happened a lot faster than the first. Now, some thirty odd years later, 1,000 point moves happen in a single day!
Headlines about the level of the Dow can grab our attention, but may make little sense to most investors, given that a “point” for the Dow and what it means to an individual’s portfolio may be unclear. The potential for misunderstanding also exists among even experienced market participants, given that index levels have risen over time and potential emotional anchors, such as a 500-point move, do not have the same impact on performance as they used to. With this in mind, let’s examine what a point move in the Dow means and the impact it may have on your investment portfolio.
IMPACT OF INDEX CONSTRUCTION
The Dow Jones Industrial Average was first calculated in 1896 and currently consists of 30 large cap US stocks. The Dow is a price-weighted index, which is different than more common market capitalization-weighted indices.1
An example may help put this difference in weighting methodology in perspective. Consider two companies that have a total market capitalization of $1,000. Company A has 1,000 shares outstanding that trade at $1 each, and Company B has 100 shares outstanding that trade at $10 each. In a market capitalization-weighted index, both companies would have the same weight since their total market caps are the same. However, in a price-weighted index, Company B would have a larger weight due to its higher stock price. This means that changes in Company B’s stock would be more impactful to a price-weighted index than they would be to a market cap-weighted index.
The relative advantages and disadvantages of these methodologies are interesting topics themselves, but the main purpose of discussing the differences in this context is to point out that design choices can have an impact on index performance. Investors should be aware of this impact when comparing their own portfolios’ performance to that of an index.
HEADLINES VS. REALITY
Movements in the Dow are often communicated in units known as points, which signify the change in the index level. Investors should be cautious when interpreting headlines that reference point movements, as a move of, say, 500 points in either direction is less meaningful now than in the past largely because the overall index level is higher today than it was many years ago.
Exhibit 1 plots what a decline of this magnitude has meant in percentage terms over time. A 500-point drop in January 1985, when the Dow was near 1,300, equated to a nearly 39% loss. A 500-point drop in December 2003, when the Dow was near 10,000, meant a much smaller 5% decline in value. And a 500-point drop in early December 2018, when the Dow hovered near 25,000, resulted in a 2% loss.
Exhibit 1. Hypothetical 500-Point Decline of the Dow Measured in Percentage Terms
HOW DOES THE DOW RELATE TO YOUR PORTFOLIO?
While the Dow and other indices are frequently interpreted as indicators of broader stock market performance, the stocks composing these indices may not be representative of an investor’s total portfolio.
For context, the MSCI All Country World Investable Market Index (MSCI ACWI IMI) covers just over 8,700 large, mid, and small cap stocks in 23 developed and 24 emerging markets countries with a combined market cap of more than $50 trillion. The S&P 500 includes 505 large cap US stocks with approximately $23.8 trillion in combined market cap.2 The Dow is a collection of 30 large cap US stocks with a combined market cap of approximately $6.8 trillion.3
Even though the MSCI ACWI IMI, S&P 500, and Dow are all stock market indices, each one tracks different segments of the market, so their performance can differ significantly over time, as shown in Exhibit 2. Since 1995, the Dow has outperformed the S&P 500 and MSCI ACWI IMI by an average of 0.5% and 3.3%, respectively (based on calendar year returns). However, relative performance in individual years can be much different. For example, in 1997, the Dow underperformed the S&P 500 by 8.4% but outperformed the MSCI ACWI IMI by 13.9%.
Exhibit 2. Performance of MSCI ACWI IMI, S&P 500, and Dow by Calendar Year
It is also important to note that some investors may be concerned about other asset classes besides stocks. Depending on investor needs, a diversified portfolio may include a mix of global stocks, bonds, commodities, and any number of other assets not represented in a stock index. A portfolio’s performance should always be evaluated within the context of an investor’s specific goals. Understanding how a personal portfolio compares to broadly published indices like the Dow can give investors context about how headlines apply to their own situation.
News headlines are often written to grab attention. A headline publicizing a big point move in the Dow may trigger an emotional response and, depending on the direction, sound either exciting or ominous enough to warrant reading the article. However, after digging further, we can see that the insights such headlines offer may be limited, especially if investors hold portfolios designed and managed daily to meet their individual goals, needs, and preferences in a broadly diversified and cost-effective manner.
If you need to better understand the point of your plan, get in touch.
1Market capitalization is the product of price and shares outstanding.
2500 companies are included in the S&P 500 Index. However, because some of these companies have multiple classes of stock that meet the requirements for inclusion, the total number of stocks tracked by the index is 505.
3Market cap data as of January 31, 2019.
Adapted from Dimensional Fund Advisors LP March 2019 Issue Brief.
Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss.
There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal.
All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investors should talk to their financial advisor prior to making any investment decision