So InKleined
by Linda B. Klein, M.Tax., J.D., R.F.P
(Send your questions on any aspect of financial planning c/o this
publication. Please include your name, address, and phone number.)
SOUND INVESTING: UNDERSTANDING "THE DOW"
AND CAPITAL GAINS
The Dow Jones Industrial Average has been setting many
records recently. Is it too late to jump aboard that bandwagon?
What is "The Dow" anyway?
An index, any index, works like a barometer, in that its
movement up or down on a pre-determined scale can be
compared to some standard or neutral state such that the
difference or the rate of change can be measured in a meaningful
way. The Dow Jones Composite Index is comprised of the stock
of 60 companies: 30 industrials, 20 transportation, and 10 utilities.
"The Dow" has become a shorthand reference to the 30
industrials' shares. Somewhat arbitrarily, this index reflects the
health of the investment climate, hence the economy.
Any way you look at it, our national economy today is
vastly different than a mere half-century ago: our financial and
natural resources, our technologies, our means and methods of
production, our labor force, the shift in GNP from primarily
manufacturing to service, etc.. Companies too go through
changes if they are to remain competitive; over time, some may
still be strong and even continuing to expand, while others have
declined or even ceased to exist because of failure or takeover.
Not so long ago, conglomerates were the rage as corporate
America sought strength in diversification. Conversely, now
companies are more commonly downsizing, and the mergers
which do come about are between companies whose profit
centers are similar; greater integration is often the desired result.
Correspondingly, the "30 industrials" have changed as well -- not
only in terms of the mix of companies, but also with respect to
each of the included companies -- and The Dow has been
"adjusted" to reflect these differences.
Because The Dow has been used routinely for decades as
a yardstick of performance, many investors tend to anchor their
portfolio with the stocks of the 30 industrial companies. The
success of this practice eventually led to so-called "index funds"
and "index annuities" whereby professional portfolio managers
target or buy exclusively the 30 industrials' stocks. Of the many
factors at play in establishing the trading range of a stock,
perhaps the most important at any given time is supply versus
demand. The ownership of every corporation is represented by
its shares of stock -- however many have been authorized by its
board of directors and then issued to shareholders. A publicly-
held corporation, especially one listed on the New York Stock
Exchange, will generally have upwards of perhaps a million
shares issued, and actively traded. With even greater attention to
The Dow brought about by the index funds, demand for the
shares of the 30 industrials naturally increases and thereby drives
up the index still further.
Other influences fuel this dynamic, most notably interest
rates and demographics. Stocks are generally the favored
investment vehicle during periods of rising interest rates (by
investors seeking a "hedge" against perceived inflationary
pressures), or during periods of steady but low interest rates (by
investors living on "fixed" incomes). Today's healthy economy
with stable and relatively low interest rates supports a continued
demand for stocks. In addition, overall, people are living longer
and many are retiring earlier. As a result, every day more and
more individuals are contributing money into retirement savings
plans of one kind or another; every day more and more insurance
premiums and annuity purchases are investedby insurance
companies.
Where do all of these investment dollars go? The
overwhelming majority get put into stocks, and a significant
portion of that amount goes to buy shares of the 30 industrials
which comprise The Dow. For the reasons discussed above, I
believe that The Dow will continue to rise, and although not
necessarily without occasional "corrections" and "profit-taking,"
at a greater rate than the broader market. Therefore, there is still
plenty of opportunity for lucrative investing.
|
|
