Diversified or Balanced Index.

March 27, 2009 by
Filed under: Finances 


If you are invested in a fund that follows the Dow Jones Industrial Average (DJIA) the chart on the left shows the percentage allocation you had on February 23, 2009 by index component.  You may think you are diversified, which is true, but you are by no means balanced.  10% of your investment is in IBM shares and less than 1% is in GM.  Although you may be thankful for the latter it makes the point that you are not balanced at all.  This has to do with the way the DJIA is calculated.  Diversification is all you hear from Cramer to Orman to your local financial adviser. The indexes, major indicators, or SMIS (Security Market Indicator Series) like the Dow Jones Industrial Average (DJIA) or S&P500 are a sure way to diversify since buying into them means buying 30 or 500 companies from technology to financials to automotive (good luck with the last two).  That is fundamentally correct. However, the way the index is calculated is the trick, especially in times of turmoil like the present.

According to Forbes’ Investopedia (http://www.investopedia.com/articles/02/082702.asp) the Dow is a price-weighted index which means that it gets calculated by simply adding up the price of each of the 30 stocks divided by a “constant” called the Dow divisor. For those of us that are geeky its current value is 0.1255527090.  For example, according to Yahoo Finance (http://finance.yahoo.com/q/cp?s=%5EDJI) the 30 DOW components closed on Feb 23th, 2009 as follows:


So the DOW’s pathetic 11-year low is calculated by adding all these stock prices and dividing by 0.1255527090 = 7114.780773.   Besides wiping down 11 years of “growth” it has done something more relevant: it has made some components more important than others because they have lost less. If you compare the influence of IBM vs. Citigroup (C), the former at 84.37 and the latter @ 2.14 (after an almost 10% rally, mind you) you’ll see what I mean. A 10% gain in IBM will mean around 0.94% in the Dow whereas a 10% gain in C will only mean a 0.024% in the DOW. in other words, C needs a 417% rally to have the same effect as a 10% IBM gain. I don’t think that the bailout can pull that off but I think you get my point.

Is there a good strategy for balancing better? you’d think so, since financial and automotive have been hammered, they have been sent to the bottom of the list.  Now let’s think what tha means for your investment.  For simplicity, let’s create a hypothetical nonexistent date where all 30 stocks’ prices open at $10, the DJIA will be at 2389 (let’s pray it is not in the future).  Two investors with $3000 each decide to invest in the DJIA that day.  Investor A buys an index fund that follows the DOW and buys 125.55 shares at $23.894 each.  Investor B buys 10 shares of each of the 30 companies.  If both remain invested that way until Feb 23, 2009 they both now have  $8932.80.  Investor A still has 125.55 shares at $71.115.  Investor B now decides to re-balance her portfolio to hold equal dollar amount per share.  The new portfolio will look as follows:


We now move to March 13 ,2009 where the DOW closed @ 7223.98.  Investor A will still have 125.55 shares, now at 72.24 or $9069.70.  Investor B however has $350.56 more with a portfolio that looks like this:


Why?  Because she sold high to buy low; the first rule of investment.  She still gets dividends and she is still invested in blue chips (not quite a warranty these days) and she is exposed to a similar risk.  Of course this case is hypothetical and has conspicuously ignored trading fees that will more than wipe $350 with at least 40 trades.  But I think it illustrates the point.

The S&P is a market cap weighted average so its calculation is different but the principal still applies, of course planning to trade all 500 shares will be cumbersome, expensive, and perhaps stupid.




One Comment on Diversified or Balanced Index.

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