Dow Jones, and S&P 500 averages are often cited to show that stocks are in general a good investment.
The stocks that are the basis of these market average indicators change over time though. It may cease to exist through failure (at least enough that exchange delists it) or mergers, or may drop so much that it is removed because it no longer fits the profile of the type of stock the average is supposed to represent. (“blue chips” or whatever)
I know that the averages account for splits, but when a company is removed from the average, and replaced by another, is there a mechanism that attempts to correct the “return” an investor would see if he had a portfolio that exactly matched that used for the benchmark?
In other words, say GM is removed from the S&P 500, and replaced with Joe’s Pharmaceutical. An actual investor would need to sell their GM stock and use the proceeds to buy JoePharm to keep their portfolio tracking the S&P. (never mind his borker’s fees) Is this accounted for somehow, or do they just swap in the better stock, and S&P blips upward as a result?
If the latter, it seems to me that claims such as “Over the long term, the S&P has beat inflation by X% / year” are worthless. Sure, if you keep dumping companies that are poor performers, and replacing them with better ones, then of course the returns are going to be decent, but do the averages account for the losses an investor would accrue by dumping those poor performers?
You don’t have to do anything special to account for splits, since (in a 2-for-1) you end up with twice the shares each worth half the price, so the average of all shares in your index won’t change.
But when the make-up of the index changes, you do have to make an adjustment. The S&P500 has a famous “divisor” in their formula which is tweaked whenever there is a change in the index, a new share offering, a share buyback, a spinoff, etc. The S&P people will adjust the divisor such that the given action does not affect the index.
The DJIA is a price-weighted index, and it most certainly is adjusted for splits and company replacement.
Say you started a new DJIA today, with 30 stocks whose prices summed to 1500, for a DJIA of 1500/30 = 50.
Now suppose that stock A, which currently trades at 60, splits its stock 2-for-1. It’s share price drops to 30. Your new average share price is 1470/30, or 49. But your index shouldn’t drop just because of a split. So you change your divisor. to return it to 50. Solve for 1470/X = 50, and X (your new divisor) = 29.4.
Suppose a month later your summed share price has risen from 1470 to 1617, bringing your index to 1617/29.4 = 55. Now you drop stick A, still trading at 30, and replace it with A2, trading at 72. Before your total value was 1617; now it’s 1659. Your raw average is 1659/30 = 55.3. But your index must stay at 55. So your new divisor = Solve for 1659/X = 55, or X = 30.16.
As you can see there is no artificial gain or loss from splits or replacements.
The DJIA is not usually used by serious investors because it badly exaggerates the effects of how the stocks in it are doing. The divisor right now is 0.132129493. This means that if the total of the prices of all the stocks goes up by 100 points, the DJIA would go up 100/0.132129493 = 756.833 points. In addition, it may not represent the way stocks are trending, since it’s so limited.
The advantage is that it’s simple, and that it can be compared to how stocks were doing at any point since it was established.
The Average’s result would be the same as an investor mimicking the Average (except for transaction costs which are quite small these days). Otherwise how could Index Funds work?
When the S&P or Dow replaces one stock with another, if their judgment is good the new stock will tend to have better future performance than the replaced stock. For this reason, you may expect to see the stock Average perform slightly better than the average stock.
(And since the incoming stock will have a quick buying spurt as index funds adjust, I suspect many try to predict S&P’s decision.)
This is actually a good point and one I’ve never found a proper answer for.
The history of the Dow is to remove stocks when they are no longer “representative” of American “industry”. (It is the Dow Jones Industrial Average, after all. There are many other Dow averages.)
From my study of its history - and I looked at it pretty closely at one time - the overwhelming pattern is that one company that is no longer doing well is replaced by a hot company that is doing well indeed.
I believe that this does bias the Dow over time. But so do many other factors, including the size of the divisor. A rise from 12,100 to 12,400 is in percentage the same as a rise from 121 to 124. But humans respond to large numbers. A 300-point rise in the Dow is psychologically more encouraging than a 3-point rise in the Dow.
The real answer is that serious economists use better factors than the Dow when trying to calculate stock returns over century-long periods. Yet they come up with answers that are not far off. The reason for that is not anything inherent in the numbers, just that the numbers inherently represent the long-term trend of the entire U.S economy, which is up.
In the short-term, though, the market can go up or down or stay the same, and has for a decade at a time. That may or may not represent the entire economy. Does anyone believe that the U.S. economy was stagnant for the entire 1960s when the Dow was? Does anyone believe that Black Monday, Oct. 19, 1987, when the Dow lost 22%, represented a fifth of the value of the U.S. economy disappearing? Of course not. All that says is that it’s hard to make money by simply leaving it in the Dow or in an index stock or any other stock buy unless your long term is an economist’s long term. The real question, again, is what’s the alternative? No other form of investment, like bonds, or real estate or commodities or art, is as easy for average investors to get into as the stock market. Since even professionals balance these investments with stocks, then stocks must have a role to play. Historically, over time, that’s been good to many people. Just ignore the Dow.
Personally, I believe that the two advantages of the DJIA (both for news reporting purposes, neither for investing purposes) are that 1) everyone’s heard of it, even those with no interests in investing, and 2) it’s been around since 1896.
As evidence of the above, I’ll just ask you to consider 1) how many generic news agencies (online, print, or TV) report religiously how the DJIA is doing and ignore all of the other indexes, and 2) how many index funds attempt to track to DJIA as opposed to, say, the S&P 500 or the Wilshire 5000 indexes.
Beyond that, it’s not a bad measure of how the largest companies are doing, and is even a reasonable approximation of how the marketplace in general is doing.
There are many indexes that are a better indicator of the performance of the marketplace as a whole because 1) they’re market-weighted from the git-go and 2) they include more of the market. Personally, I pay more attention to the S&P 500, even though I’ll freely admit that index is also weighted toward the larger companies.
