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Financial Planning Newsletter• February 25, 2011 




PLAN.INVEST.RELAX

 


Financial Planning Newsletter
February 2011

What's in an Index?:

POP Quiz: How many stocks make up the Dow Jones Industrial Average? (keep reading to find out)

It's the most quoted barometer of stock market performance in the newspapers and evening news, but do you have any idea how it is calculated?

This type of information is probably of more interest to those analytics out there that like the technical talk, but for everyone else bear with me. This will give you something to chat about at your next cocktail party and we will even explore how some savvy fund managers are trying to improve upon these indexes.

Dow Jones Industrial Average (DJIA): It does seem odd that out of the thousands of stocks that trade on the US Exchanges, our most recognized measure of how the market performed is made up of the daily performance of just 30 stocks! Yes, that is correct just 30 non-randomly selected Large cap "blue -chip" stocks make up the Dow. The Dow is a Price Weighted Index which is calculated by totaling the prices of the 30 stocks and dividing the sum by a divisor which has been adjusted through the years to account for stock splits. The complaint that many have with the Dow is that as a price-weighted index a higher price stock carries more weight and affects the results than a lower price stock. You can have two stocks, one at $50 per share and one at $25 per share with the same market cap (shares outstanding X price) but a 5% movement in the higher price stock will affect the index more than the lower one.

S&P 500: The second most quoted index is of course the S&P 500, which is pretty much the benchmark most money managers follow. The S&P 500 is made up of 500 stocks, so it has much better sampling of the overall market. However the S&P 500 is still considered a "Large Cap" type index because of the way it is constructed. The S&P 500 is a Cap-Weighed Index which means that the components of the index are weighted according to the total market value of the company. Once again the complaint that many have is that the weighting of the big cap companies overpowers that of smaller ones in determining the overall index performance.

To explain in another way, the top 10 holdings of the S&P 500 (10 stocks out of 500) make up 19% of the indexes return. Here is a list of them:

Exxon Mobil Corporation Common   3.48%
Apple Inc.   2.66%
General Electric Company Common   1.83%
Microsoft Corporation   1.78%
International Business Machines   1.72%
Chevron Corporation Common Stoc   1.63%
Bank of America Corporation Com   1.54%
AT&T Inc.   1.51%
Procter & Gamble Company (The)   1.51%
JP Morgan Chase & Co. Common St   1.50%

.

Variations on the Indexes:

Research Associates created the RAFI index as a solution they saw to the fundamental flaws in the S&P 500. Their complaint was that if you were an Index Fund investor you were putting money into stocks that may be fundamentally overvalued just because they were the biggest weighting in the index. If you look at the top 10 holdings, while they may be very good companies, it is a self fulfulling prophecy that they keep going up as the market rises just because they get the bulk of new money flow into the index. They may be completely overvalued and trading at fundamentally unjustified share prices but that would not matter. The RAFI approach is to select and weight securities based on fundamentals, not just market cap. Studies have shown that this method does produce a better return over time.

 

Equal Weighted S&P 500: several funds have also come out with variations to play the S&P which balances out the percentages of each holding. The Equal Weight S&P index applies a weighting of .2% for each of the 500 holdings. Studies have shown this to outperform it's cap-weighted cousin over time.

So there you have your talking points for the next cocktail party. Next month we will explore mutual funds and ETF's.

 

Completely unrelated to personal finance: My father in law showed me this video and I thought it was the wildest thing I had seen. I don't know anything about the team or quarterback, but this guy is unreal. So here is a little entertainment for your Friday:

Uconn trick shot quarterback

 

 



James A. Daniel,
CFP®

This newsletter if for informational purposes only. The information contained within should not be considered as financial advice nor soliciation for financial services. Consult with your financial professional if you have any questions.

The Advisory Firm, LLC is a fee-only financial planning company and registered investment advisor.


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