Weekend Economists Celebrate September 13-15, 2013

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7. It Doesn't Make Much Sense To Invest Like The Dow

http://www.businessinsider.com/why-benchmarking-your-portfolio-is-a-losing-bet-2013-9

Just recently it was announced that the Dow Jones Industrial Average will undergo some changes as three companies are removed (Bank of America, Alcoa and Hewlett-Packard) to be replaced by Goldman Sachs, Nike and Visa. However, the reality is that while the changes are of interest only to people involved in the financial markets as the Dow Jones Industrial Average is no longer relevant as a representation of America's industrial complex or most individual's portfolios. One of my favorite writers, Neil Irwin, recently wrote in the Washington Post:
"The announcement of the changes shows the absurdity of the index. 'The index changes were prompted by the low stock price of the three companies slated for removal and the Index Committee's desire to diversify the sector and industry group representation of the Index,' the company said.

Of course, the per-share price of a stock has absolutely nothing to do with its size, importance or representativeness. Bank of America is being booted, it would seem, for its sub-$15 per-share price, in favor of Goldman Sachs with a $164 share price. But Bank of America is a way bigger company! Its total market capitalization is $155.6 billion, to $74.5 billion for Goldman. It has 257,000 employees, to 32,000 for Goldman. It is engaged in banking and lending activity in basically every community in America, as opposed to Goldman's specialty investment banking business. But when you find yourself in the archaic trap of weighing companies based on their per-share price, that's the kind of absurdity you end up with."

However, these changes highlight a much bigger issue to investors. I recently wrote an a article entitled "Why You Can't Beat The Index" which covered the variety of flaws of how benchmark indexes are calculated and the effect on portfolios.

"The sad commentary is that investors continually do the wrong things emotionally by watching benchmark indexes. However, what they fail to understand is that there are many factors that affect a 'market capitalization weighted index' far differently than a 'dollar invested portfolio.'"



Read more: http://www.streettalklive.com/daily-x-change/1815-why-benchmarking-your-portfolio-is-a-losing-bet.html#ixzz2esAXoXIa