It was announced last week that there is going to be a change to the components of the Dow Jones Industrial Average. Although, changes in Dow components are not unusual, this is the most significant change in a number of years. At a high level, there are three companies leaving the Dow and three companies joining. The three companies leaving include Pfizer, the pharmaceutical giant which joined the Dow in 2004, Raytheon Technologies, which in one form or the other has been part of the Dow since 1939, and Exxon Mobil, the Dow’s longest lasting component as a member since 1928. The three companies joining include Honeywell International, the industrial conglomerate, Amgen, the biotech firm, and Salesforce, the customer relationship management specialist. According to the press release, the primary reason given was Apple’s recent announcement that its stock would split 4 to 1. As a result of the split, the Dow’s exposure to the information technology sector of the economy would be reduced. You may ask why would a stock split which has no affect on a company’s value reduce the Dow’s exposure to a sector of the economy. The reason has to do with the way the Dow is calculated.
The Dow Jones Industrial Average is calculated not based upon a company’s market value (market value = number of outstanding shares x share price) as most indexes are calculated; rather, the Dow is calculated according to share price. Therefore, when Apple splits its stock, its weighting on the Dow will decline. Currently, Apple is the largest component of the Dow by the fact that its stock is priced at over $500 a share. And, Apple accounts for a little over 12 percent of the Dow but after the split, it will be a little over three percent.
With the aforementioned being said, the most important thing to understand is what this means for you and me as investors. To answer that, it’s necessary to have a bit of knowledge about the Dow. The Dow measures the daily price movement of 30 large U.S. companies. The 30 companies are selected to provide a broad overview of the general U.S. market conditions. It doesn’t measure the total U.S. economy because small businesses, the lifeblood of American business, are not represented in the index. That being said, the Dow is the most quoted index and the one, unfortunately, too many investors rely upon.
I say unfortunately because too many investors think that their portfolios should match the performance of the Dow. That is a mistake. First of all, since the Dow is price weighted, it gives greater weight to an expensive stock versus a cheaper stock. In all my years in the investment world no one has ever been able to explain to me why that makes sense. Apple is Apple whether its stock is selling for $500 a share or $125 a share. Second, the Dow only tracks 30 U.S. companies. In a balanced and diversified portfolio, which you should have, not only are you going to have small and medium-size companies in your portfolio, but you’re also going to have exposure to international companies. None of these companies are tracked by the Dow. Third, in a well-balanced and diversified portfolio you’re going to have cash and fixed-income investments such as bonds. The Dow assumes that you are 100 percent invested in stocks at all times, which for the great majority of investors is a mistake.
I am not saying you should not look at the Dow Jones Industrial Average, because I do every day. However, I do not make investment decisions based upon the Dow and neither should you. Yes, the Dow gives a general direction of the market; however, because it is price weighted, it is possible for 25 out of the 30 stocks to lose money and for five to make money, and the overall index to go up. If you had invested in the 20 stocks that had declined, what happened in the overall index would be immaterial to you.
There will be some short-term disruption in the Dow because of the changes and Apple’s split. However, before too long the Dow will return to normal and what that means is that it’s a nice number to look at to get a general idea of the market. However, it is not something you should use to guide your investment decisions.
Rick is a fee-only financial advisor. If you would like Rick to respond to your questions, please email Rick at email@example.com.