Investors may be tempted to extrapolate recent returns into the future, which can lead them to abandon their investment philosophy at potentially inopportune times. While negative outcomes are disappointing, investors should view them with the proper perspective and stay the course.
When you leave your server a tip, do you round it to a whole-dollar amount and often in multiples of $5? Does a 60th birthday seem more significant than a 59th? If you answer yes to these questions, you’re not alone. Most of us prefer round numbers.
A quick online search for “Dow rallies 500 points” yields a cascade of news stories with similar titles, as does a similar search for “Dow drops 500 points.”
These types of headlines may make little sense to some investors, given that a “point” for the Dow and what it means to an individual’s portfolio may be unclear. The potential for misunderstanding also exists among even experienced market participants, given that index levels have risen over time and potential emotional anchors, such as a 500-point move, do not have the same impact on performance as they used to. With this in mind, we examine what a point move in the Dow means and the impact it may have on an investment portfolio.
IMPACT OF INDEX CONSTRUCTION
The Dow Jones Industrial Average was first calculated in 1896 and currently consists of 30 large cap US stocks. The Dow is a price-weighted index, which is different than more common market capitalization-weighted indices.
An example may help put this difference in weighting methodology in perspective. Consider two companies that have a total market capitalization of $1,000. Company A has 1,000 shares outstanding that trade at $1 each, and Company B has 100 shares outstanding that trade at $10 each. In a market capitalization-weighted index, both companies would have the same weight since their total market caps are the same. However, in a price-weighted index, Company B would have a larger weight due to its higher stock price. This means that changes in Company B’s stock would be more impactful to a price-weighted index than they would be to a market cap-weighted index.
Dimensional’s Co-CEO and Chief Investment Officer answers questions about investment returns, benchmarks, and evaluating managers.
Investors often start the year by evaluating how their portfolios have performed. Gerard O’Reilly recently sat down with Scott Mardy, a Vice President and Investment Strategist with the firm, to talk about what investors should consider when evaluating investment performance.
- Your performance evaluation framework should answer a simple question: Has your money manager delivered what they committed to deliver?
- The point of analyzing performance data is to help investors make informed investment decisions. The noisier the data, the weaker the inferences you can make.
- If you’re going to invest time understanding how a manager operates and potentially commit assets to them, you want a manager who is as committed to the long term as you are.
- Over short time periods, outperforming or underperforming a benchmark is not necessarily evidence that a manager failed to deliver what they said they would deliver.
- There’s no magic time frame for considering returns—different time frames provide different information.
A Question of Equilibrium
“Sellers were out in force on the market today after negative news on the economy.” It’s a common line in TV finance reports. But have you ever wondered who is buying if so many people are selling?
The notion that sellers can outnumber buyers on down days doesn’t make sense. What the newscasters should say, of course, is that prices adjusted lower because would-be buyers weren’t prepared to pay the former price.