News media often focuses on the Dow Jones Industrial Average (Dow or DJIA) as the pulse of the economy. Although the performance of the DJIA is a good indication of how U.S. equities are performing, one index alone does not paint a complete picture of the global economy – present or future. Markets react to a number of different inputs – political factors, commodity prices, government policy, earnings reports, and so on. Sometimes they get it right and trepidation in the markets signals risks to the broad-based economy. Other times, financial markets overreact. As economist Paul Samuelson once mused, the stock market has predicted nine out of the last five recessions.
What is the DJIA?
The Dow Jones Industrial Average is one of the most notable stock market indexes, established in the 1890s. Investors all over the world follow the performance of the DJIA to forecast broad market trends; it is so popular that it is often called “the market.” It provides investors with financial data about how 30 large publicly traded United States businesses have performed in a standard trading session in the stock market. The Dow includes companies from most of the US industries aside from utilities and transportation; companies such as Wal-Mart, Verizon, Microsoft, Nike, Exxon Mobil and General Electric are on the list.
What are the Limitations of the DJIA?
Investors may not want to base their entire market sentiment on the performance of the DJIA as a gauge for the stock market because it may be an incomplete indicator. The Dow is not an average of the performance of all American publicly owned companies, but only 30 of some world’s largest and most well-established blue chip companies, worth over $10 billion. A Wall Street Journal committee arbitrarily picks the businesses that are believed to be representative of the entire market. Although the stock prices of these organizations can greatly fluctuate, they have a lower risk of going bankrupt compared to the other thousands of publicly traded companies.
The Dow is a price-weighted index; each company’s price determines its portion of the entire index. Unlike the S&P 500, which is weighted by its relative value, the DJIA is weighted by share price, which can be problematic. In a scenario where company A has 10,000 shares at $20 each and company B has 1,000 shares at $200 each, even though they have the same market capitalization, company B would have more weight in the index.
Another limitation of the Dow is that the index views stock price changes only as a dollar value, ignoring how meaningful a percentage change is relative to the underlying security. For example, a $5 price increase in company A’s stock can be offset by a $5 decrease in company B’s stock. In effect, the 25% price increase in company A’s stock is leveled by a 3% decline in company B’s stock.
Using Benchmarks to Evaluate Your Investment Performance
Market indexes are certainly not without purpose. They provide a widely accepted benchmark and can give investors a quick 10,000-foot view of trends in the market. For an investor, the key is not to panic and become an emotional investor. When watching the movements of market indexes, keep your personal asset allocation in mind. Although many of us are invested in the firms that comprise the major U.S. benchmarks, a diversified portfolio will contain more than just these securities. That isn’t to say that the ripple effect won’t impact other securities, but with proper diversification and risk mitigation, your portfolio shouldn’t bear the full weight of the decline in any one index.
No one likes to see their portfolio suffer through a market downturn. Unfortunately, market corrections are inevitable and should be expected; after all, investing is not without risk. Take the opportunity to reassess your risk preferences in conjunction with your time horizon and goals to ensure the current path is the best one for you.
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