While the Dow and other indices are popularly interpreted as indicators of broader stock market performance, the stocks composing these indices may not represent an investor’s actual portfolio or strategy.
A quick online search for “Dow rallies 500 points” yields a cascade of news stories with similar titles, as does a similar search for “Dow drops 500 points.” These types of headlines may make little sense to many investors, given that a “point” for the Dow and what it means for their own portfolios is unclear. The potential for misunderstanding also exists among even experienced market participants. Given that index levels have risen over time, 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 consider what a point move in the Dow means and its impact on an hypothetical 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 like the S&P and Russell indexes.1 An example may help put this weighting methodology difference 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 another topic, but our purpose of discussing these differences is to point out that design choices can have a large impact on index performance figures. Investors should be aware of this impact when comparing their own portfolios’ performance to a particular index.
HEADLINES VS. REALITY
Movements in the Dow are often communicated in units known as points, which signify the level of index change. Because of this different methodology, investors should be cautious when interpreting headlines that reference point movements. A move of, say, 500 points in either direction is much less meaningful today than in the past largely because the overall index level is much higher today than it was many years ago. Exhibit 1 plots the magnitude of this decline 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 only a 2% loss.
The chart illustrates what a 500-point drop would have been in percentage terms for the Dow Jones Industrial Average on a daily basis. It assumes a 500-point loss took place each trading day from January 1, 1985, to February 1, 2019, and uses daily historical closing values of the Dow Jones Industrial Average to compute the percentage change. Percentage change does not indicate the actual change in the Dow during the period shown. Actual results may vary.
HOW DOES THE DOW RELATE TO YOUR PORTFOLIO?
Furthermore, while the Dow and other indices are interpreted by the media as indicators of broad stock market performance, the stocks composing these indices do not represent what may be a globally diversified portfolio even if entirely in equities. 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%.
MSCI ACWI IMI is the MSCI All Country World Investable Market Index (net dividends). Their performance does not reflect fees and expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results. It is also important to note those planning long-term investment management strategies are concerned about other asset classes besides stocks. Depending on investor needs, a professionally diversified portfolio targeted toward the risk preferences, risk capacity and risk adhesion of a family a will often include a mix of global stocks, bonds, commodities, and any number of other assets not represented in a commercial stock index. A portfolio’s performance should always be evaluated within the context of an investor’s specific goals and time horizons for planning. 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—or when comparing portfolios with a friend or colleague. An acute case of “returns envy” can often result in disappointment or even disaster if a sound strategy is abandoned simply to out-perform a neighbor.
News headlines are written to grab your attention. A headline publicizing a 500-point move in the Dow is intended to trigger an emotional response and, depending on the direction, will sound either exciting or ominous enough to warrant reading the article. However, for serious wealth management, attention-getting headlines rarely offer practical insight for achieving reliable planning outcomes, especially for those investors with a philosophy based on modern financial science and a strategy integrated with their individual goals, needs, and preferences in a broadly diversified and cost-effective manner.
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.