The Dow Jones Industrial Average (DJIA or the "Dow") closed above 20,000 for the first time on January 25, 2016. It was a page one news story in the Wall Street Journal and many other publications. The S&P 500 Index and the NASDAQ set records the same day but did not receive as much attention.
According to the Wall Street Journal, "Applause, whoops and cheers erupted on the floor of the New York Stock exchange." So it must be important. Right?
Here are some reasons why Dow 20,000 doesn't matter:
The Dow is a very narrow index
The DJIA was designed in 1896. It had to be simple to calculate because there were no calculators, computers, etc.
To keep the index simple, there were only 12 stocks (today, there are only thirty) and the index was "price weighted". Price weighted means that the Dow was calculated by adding the prices of the 12 stocks and then dividing by 12. (Source: Investopedia.com).
Today, it is calculated by adding up the price of 30 stocks and dividing by the Dow's "divisor." The Wall Street Journal states that the divisor "is a figure that adjusts for the effect of stock splits and other changes over time… (Otherwise, for example, a stock's 2-for-1 split would suddenly throw off the Dow.). The divisor is... 0.14602128057775." The divisor changes over time.
Price weighting is a poor way to construct an index. It means a $20 stock has twice as much influence on results as a $10 stock, even if there are twice as many shares outstanding for the $10 stock. As a result, there is no consistent relationship between the size of a DJIA component and its effect on the index.
For instance: The Dow's strange focus on share price gives far more weight to Goldman Sachs Group (NYSE:GS) than the bank's market value deserves. At $236.59 a share, it is the most expensive stock in the average, meaning it has twice as much of an effect on the average as Apple Inc. (NASDAQ:AAPL), which has a market capitalization more than six times that of Goldman." (Source: "We're Already at Dow 30,000, You Just Don't Know It," Wall Street Journal, January 25, 2017)
A thousand point change isn't what it used to be
The first 1,000 point Dow increase was January 1987 when it hit 2002. That was a 100% increase from 1,000. Each subsequent 1,000-point increase represents a smaller percentage change. Going from 19,000 to 20,000 was only a 5.3% increase.
The Dow is actively managed
The Dow is not what I would call a naturally occurring index. The stocks included are chosen by a committee and change over time. Some of the decision makers are editors at the Wall Street Journal. Does being a Wall Street Journal editor make someone an expert stock picker?
Compare that to the Russell Indexes. The Russell 3000 index is naturally occurring. It is the 3,000 largest US companies by market value (number of shares x price per share). Once a year it is changed to reflect changes in company value. No active management there.
It does not include dividends
Dividends paid by the 30 DJIA companies do not affect the index returns but they greatly increase investors' returns. This is true of most indexes. Investors in index mutual funds or exchange-traded funds do benefit from dividends. As a result, index funds usually have a higher rate of return than the return for the indexes that they are based upon.
Over the last 15 years, reinvested dividends would have added 57% to the return of a DJIA index fund and 47% to an S&P 500 Index Fund.
The allocation of the DJIA probably doesn't match your portfolio
Most investors are invested in stocks and bonds. The DJIA is all stocks. It contains only large-cap stocks, mainly value and blend. When stocks are doing well, the DJIA will outperform portfolios containing both stocks and bonds. When stocks are declining, the DIA will probably underperform.
What goes up will come down
Past performance is no guarantee of future performance and Dow 20,000 is not a reason to increase or decrease your investment in stocks. Investors need to be aware that the Dow and other stock market indexes increase and decrease over time.
The DJIA is overdue for a 20% or greater decline. On average, historically, 20%+ Dow declines occurred every 3.5 years. As of today, the Dow hasn't had a decline of that size in almost eight years!
An "embarrassing anachronism"
According to Wall Street Journal columnist James Mackintosh, the Dow "is an embarrassing anachronism, abandoned by professionals and beloved only by a media that mostly knows no better. It needs to be updated or, better, replaced... It is not a good measure of the broad market - indeed it is not even designed to be. It is not a good guide to investing. It is not calculated in a sensible way. And it isn't even right... Correct for mistakes dating from the days of paper and slide rule, and the Dow, in fact, passed 30,000 for the first time last month."
What is important for investors is the return on their investments over time, volatility, taxes on investments, inflation, how closely the allocation of their portfolios match their actual risk tolerance, time horizon and need for income from their investments. The Dow hitting 20,000 doesn't affect any of these.
It is not "Don't worry, be happy." Nor is it "Worry, don't be happy." It is more like "Keep calm, carry on and don't pay attention to Dow 20,000."