Don't Invest Like the Dow

Jun.10.09 | About: SPDR Dow (DIA)

I always get excited when changes to the Dow Jones Industrial Average (DJIA) occur. I don’t really know why. But you can bet I was glued to my TV when Chevron, Bank of America, and Kraft replaced Honeywell (NYSE:HON), Altria (NYSE:MO), and AIG (NYSE:AIG) last year. This year, the DJIA has changed yet again, with Cisco (NASDAQ:CSCO) and Travelers (NYSE:TRV) replacing GM (NYSE:GM) and Citi (NYSE:C).

The DJIA is meant to reflect the overall US economy, comprised of a mix of the largest companies in different sectors. The stock pickers over at News Corp. (NASDAQ:NWS) (who select the Dow 30 components) do a pretty decent job of creating a representative sample of the US economy. What the folks over at News Corp. are not good at is making money in the stock market. If you’re looking for a successful investment strategy, don’t look to the DJIA.

The DJIA tends to change whenever one of its components performs badly…usually very badly. Those companies that are struggling to survive get kicked out of the index, replaced by a strong company with strong historical growth. AIG got kicked out after the bailout fiasco, while GM only got kicked out after declaring bankruptcy. These companies were replaced with companies that performed well compared to the companies they replaced, which is reflected by their stock prices. When Kraft replaced AIG on September 18, it was trading within 10% of its five-year high. Cisco was significantly outperforming the S&P 500 when the announcement to replace GM was made.

The issue with this index is that it buys high and sells low. When companies become market leaders, after years of considerable growth, they become eligible for the index, while shrinking companies in the index find themselves on thin ice. Fortunately, the folks over at News Corp. aren’t interested in buying low and selling high, they’re interested in maintaining an accurate reading on the economy.

You on the other hand are interested in making money…by buying low and selling high. One word of advice for you investors out there is to follow the exact opposite strategy of the DJIA. Instead of buying companies whose stock prices are climbing higher, you should be looking for healthy companies that have depressed stock prices.

Stock prices are like roller coasters. Initially they go higher and higher, but at some point they come back to earth. Look at any five year history of a company’s stock price and you’ll see that. Stocks never continually go up. They go up for a while, then pull back a little bit, then march on. The key is to capitalize on the moments when those stocks pull back.

When we see a stock start climbing the market roller coaster, we get overcome with emotion. We think that it will continually climb higher and higher, and if we don’t hurry up and buy it now, we’ll end up paying more for it later.

Unfortunately, that’s rarely the case. We jump when we see a stock take off, and end up buying just as the roller coaster runs out of steam. The stock price falls in value, we panic, and sell at a loss. Our excitement over the prospect of an ever climbing stock price causes us to lose money.

Now imagine that you bought a stock when it was on its way down the market roller coaster. Maybe you bought Apple (NASDAQ:AAPL) in December of 2000, or Burlington Northern Santa Fe (BNI) in November of 2002. These stocks got too hot too fast, and both suffered sharp drops. If you waited for these drops and held onto these stock for the next few years, you’d have done very well.

This seems really easy to do. Find a stock you like, watch it, and wait for a few bad days to buy in. But once you actually find that stock, it becomes very difficult to stand by and wait. It may take a few weeks or even months, but waiting for those pullbacks will eventually pay off for you down the road.

So don’t be like the Dow. Don’t buy in when a stock’s doing awesome. Wait for it to pull back, and then dive right in.

-Nick Klein

Disclaimer: None