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MAKING CENTS OUT OF THE NEWS
Blog #23
(June 11th, 2009)
INVESTMENT SELECTION IS NO PERFECT PROCESS!
By Tom McAllister, CFP™
Two icons of U.S. business have been deleted from the Dow Jones Industrial Average.
The editors of the index have replaced Citigroup, Inc. with the Travelers Companies. Cisco Systems, Inc. is going in for General Motors Corporation. Both these changes took effect with the opening of trading on June 8th. These changes follow a change made last year, when American International Group was removed and Kraft foods added.
There were good reasons for this year's changes. General Motors had to be removed when it declared bankruptcy, rendering its stock worthless. Citigroup is in the midst of massive restructuring, likely to result in the U.S. government owning a large, probably a controlling, stake. Ironically, Travelers, now replacing Citigroup, was a part of Citigroup from 1998 until 2002.
Dow Jones called Cisco a fitting addition to the index "because its communications and computer-networking products are vital to an economy and culture still adapting to the Information Age - just as automobiles were essential to America in the 20th Century."
As for Cisco, it would appear the company has been a far more important factor in the United States economy for a number of years now as compared to General Motors.
The changes won’t cause any disruption in the level of the index,
Dow Jones says. The divisor used to calculate the Dow from its components’ prices on their respective home exchanges was changed prior to the opening on June 8. This procedure prevents any distortion in the Dow’s reflection of the U.S. stock market.
By way of background, The Wall Street Journal’s Managing Editor oversees the makeup of “The Dow”. The index, created in May1896 by Charles H. Dow with twelve stocks, is today among the best-known stock market barometers in the world. In modern times the index is composed of 30 stocks, all of which have a very large capitalization. No longer a true “Industrial” index, the Dow now includes a mix of important sectors of the economy, from financials to high tech as well as conglomerate General Electric.
While investors often measure "the market" by the Dow Jones, we in the professional investment community have long ago begun to use broader indices to gain a clearer picture of the entire market.
The most popular comparative index for us these days is the Standard and Poor’s 500 Index.
The
S&P 500
is a U.S.
market index
that gives
investors
an idea of the overall movement in the U.S.
equity
market. The value of the S&P 500 constantly changes based on the movement of 500 underlying
stocks
The index is computed by
weighted average market capitalization
The first step in this methodology is to compute the
market capitalization
of each component in the index. This is done by taking the number of outstanding
shares
of each company and multiplying that number by the company's current share price, or
market value
. Next, the market capitalizations for all 500 component stocks are summed to obtain the total market capitalization of the S&P 500. This market capitalization number will fluctuate as the underlying share prices and outstanding share numbers change. Note that the S&P numbers are reported in "points", not dollars.
Because of the much heavier impact the largest component stocks have on the index, the S&P 500 is not an ideal indicator of what the overall market is really doing. Other indices, for example the Wilshire 5000 and the Russell 3000 Indices, give investors a clearer picture of the overall market. But the S&P 500, along with the Dow Jones Industrials and the NASDAQ index of high tech and financial stocks, are the ones most widely reported by the media. Thus, most of us revert to the S&P 500 index as our comparison, since its large capitalization components probably make up over 90% of U.S. stock market activity.
Even after forty-seven years in this field, I am forced to admit - Investment selection is no perfect science!
With all the rapid changes in our economy and in the investment markets, there are many investors who would benefit from more consistent guidance. We are currently accepting new financial planning and investment clients, and would appreciate your referrals.
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