Dashing for the last train of the night after dawdling too long is risky. Do it too often and chances are one day you'll arrive at the platform just as the train pulls away from the station.
It's the sort of regret I imagine was felt by the keepers of the venerable Dow Jones Industrial Average as they saw Apple steam to new highs. But, after years of dawdling, Apple will be added to the Dow at the close of business on Wednesday and AT&T will be removed to make room for it.
Problem is, Apple's best days – as an investment – are probably behind it. After all, it's the largest stock in the land and it'll struggle to grow as quickly as it did in the past. Over the long term, Apple's crown will eventually be taken by another.
The speed of Apple's denouement is a matter of some debate. But the Dow has a habit of adding stocks to its portfolio of 30 companies at inopportune times. That's according to a paper by Anita Arora, Lauren Capp and Gary Smith of Pomona College titled Do stocks added to the Dow outperform the stocks they replace? They figure the stocks added to the Dow, from 1929 through 2004, gained an average of 3.4 per cent over the following 250 trading days. Stocks that were removed from the Dow gained an average of 19.3 per cent over the same time frame.
But that's not to say Apple is doomed to underperform AT&T because being added to the Dow isn't the kiss of death when it comes to returns. In the past, some additions went on to be winners and some of the departing stocks deserved the demotion.
My main beef isn't with Apple but with the Dow itself. While I don't want to see the average fade away entirely, it should be retired and replaced with a more diversified index such as the S&P 500 for most purposes.
From a modern perspective, the Dow is constructed in a peculiar way. Its value is calculated by adding up the prices of the 30 stocks it holds and the result divided by a divisor, which accounts for stock splits and similar events.
Most modern indexes use weighted averages with the weights being linked to a stock's market capitalization, or size. For broad market indexes, such as the S&P 500, the idea is to track a portfolio that looks very much like the market.
The difference between the two methodologies becomes apparent when you compare the major holdings of the Dow to those of the S&P 500.
The top Dow stock is currently Visa, which represents about 9.6 per cent of its portfolio due to its high share price. The second largest holding is Goldman Sachs at 6.7 per cent, and 3M takes third spot at 5.9 per cent.
In contrast, there are 20 stocks that are larger than Visa in the S&P 500 and more than 40 that are larger than 3M or Goldman Sachs. Each of the three stocks represent less than 1 per cent of the S&P 500's portfolio.
On the other hand, the Dow currently doesn't hold the three largest stocks by market capitalization in the United States, which are Apple, Google and Berkshire Hathaway.
A combination of concentration and an odd approach to weighting makes the Dow behave like an actively managed portfolio run by a manager who doesn't trade much. It isn't a very good measure of the market over all.
Investors should turn away from the Dow and opt instead for something like the Vanguard Total Stock Market ETF, which tracks the whole U.S. market in a sensible way, charges only 0.05 per cent annually and holds more than 3,000 stocks. As it happens, holding Apple helped the ETF beat the Dow over the past decade. Don't be left behind with the Dow.
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