Archives for June 2011

The Dow Jones Industrial Average (DJIA) is an antiquated, somewhat-arbitrary, poorly constructed, incomplete indicator that does a subpar job of tracking the actual performance of the U.S. stock market. There, I said it. Every time I see it mentioned in the financial media down to the decimal points like it’s some hyper-accurate holy number, I get a bit annoyed.

A recent BusinessWeek article Why Apple Isn’t in the Dow served as another reminder of why I feel this way. Whether or not you like Apple, it’s the second largest company by market value in the country. Is it in the Dow Jones? Nope. Why not?

The Dow only includes 30 stocks, picked by WSJ editors. In 1896, the DJIA had 12 stocks. In 1916, it grew to 20. In 1928, it increased again to 30. It’s still just 30 stocks over 80 years later. Not only that, but it’s not even clearly defined as the largest 30 companies or something like that. It’s simply 30 companies chosen by a committee to best represent the market out of the ~5,800 publicly traded companies out there. As a result, new companies like Microsoft, Intel, and now Apple are added rather late, and major sectors like transportation and utilities aren’t even represented.

The Dow is a price-weighted index. The DJIA is not weighted according to the relative value of the companies like the S&P 500 or other “Total Market” indexes. Instead, it’s weighted by share price, something that is very arbitrary. The same company could have a million shares at $10 each, or 1,000 shares at $10,000 each. It’s worth the same, but the second company would have 1,000x the effect on the Dow Jones Index. This means Apple stock (about $330) would have the 18 times the effect of General Electric, even though it’s market value is only about 1.5 times more.

This also means you shouldn’t invest in any mutual funds or ETFs that follow the Dow either. I’m looking at you “Diamond”, the SPDR Dow Jones Industrial Average ETF (ticker DIA). By extension, this is also one of my problems with the investing start-up Betterment.com. I would never take advice from a financial planner that said a Dow Jones ETF was a critical part of my portfolio’s asset allocation.

Morningstar.com helpfully provides two types of performance data for mutual funds: total returns and investor returns. Total returns are what you usually see elsewhere, and assumes that one buys all at the beginning and holds the entire period given – the last 5 years, for example. Investor returns account for the timing of the buying and selling of investors on average. An example given is:

Assume a fund generated a 10% total return in a calendar year, with most of those gains coming in the year’s first quarter. If investors added substantial sums of money to the fund after its first-quarter runup, the fund’s investor returns for that year would be lower than the fund’s 10% total return.

Using this data, Morningstar can basically tell how the average investor was at market timing. Apparently, not so good. On average they sold too quickly after losses, and bought too late and missed part of the rebound. From the article Mind the Gap 2011:

In 2010, the average domestic fund earned a return of 18.7% compared with 16.7% for the average fund investor, making for a gap of 200 basis points. For the trailing three years, that gap was 128 basis points. For the past five years, it was 98 basis points, and for the past 10, it was 47 basis points.

For taxable bonds, the return gaps were 138 basis points for one year, 52 basis points for three years, 57 basis points for five years, and 106 basis points for 10 years. That 10-year figure is pretty large considering it meant that returns fell to 4.47% annualized from 5.53%. Municipal bonds have consistently had an even bigger gap ranging from 113 basis points last year to 173 annualized for the trailing 10 years.

To make it clear, those are huge performance gaps over time. Like saying goodbye to 25% of your nest egg huge. The data also found that people who owned balanced funds that owned both stocks and bonds did much better comparatively. This includes target-date style funds. That makes perfect sense to me, because the type of people who buy balanced funds are not the type to try to time the market.

They found similar results when comparing investors in Vanguard mutual funds that had both Investor and Admiral share classes. The more patient (and more wealthy) investors had better performance in 13 out of 15 cases, with a margin greater than the difference in expense ratios:

For example, in the firm’s flagship Total Stock Market fund, Admiral shareholders enjoyed returns of 6.16% annualized compared with 5.35% for Investor shares. At Vanguard Value Index, Admiral shareholders earned a 4.84% annualized return compared with 2.61% for Investor shares.

If you do try to time the market, you owe it to yourself to track your moves carefully (and honestly) to calculate if they were really better than doing nothing at all. Chances are, they weren’t. If you don’t do better after a certain time, say a couple years, it may be a good idea to stop while you’re not too far behind. Here are a couple of ways to find your personal rate of return that accounts for inflows and outflows.

• Estimate Your Portfolio’s Rate of Return (Calculator) – Even an estimate can be pretty helpful.
• Calculate Your Exact Portfolio Rate Of Return (Spreadsheet) – Wrote this a few years ago, but it’s still applicable.