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Guest Post: Your Mutual Fund Is Hurting Worse Than You Think

3 June 2010 One Comment

Today’s happy headline necessitates a little look back. How does today’s Dow Jones Industrial Average compare to, say, the Dow of February 1997?

Answer: It doesn’t. Sure, the average is 10,192 today and was around 6900 twelve years and 3 months ago, but…the average of what?

The Dow is the sum of the prices of 30 of America’s largest stocks, multiplied by a constant. But the roster of stocks itself isn’t constant. Here are some of the blue chips that comprised the Dow in ‘97:

General Motors

(This is already reading like a list of notorious contemporary eradications. Despite where we appear to be heading, the next items on the list are not the Seattle SuperSonics, the French franc and Lindsay Lohan’s career.)

Eastman Kodak
International Paper
Sears Roebuck
Union Carbide
Bethlehem Steel

That’s almost half the then-Dow, consisting of the infamous and the doddering. Today, these names sound as though they belong in some bygone epoch of American proto-commerce. (Woolworth, if you’re interested, took scarcely more than a generation to fall from five-and-dimes with lunch counters that wouldn’t serve black people to sneaker retail. The company shed all its fat and kept its one legitimate asset, which is now its successor company – Foot Locker.)

So yes, the Dow has “risen” 60% since the cloning of Dolly the sheep. But that’s comparing today’s Dow to something that no longer exists. A basket of 1997 Dow stocks wouldn’t have risen anywhere near 60%:  a lot would depend on whether you used your General Motors certificate to make a paper airplane out of or wipe up kitchen spills with.

Conversely, if you’d had the foresight to invest in stocks that were to become Dow components –Verizon, AT&T, Chevron, Cisco, Intel, Pfizer et al. – you’d have enjoyed a lot more than a 60% return over 12 years. But you’d have had to predict that cell phones would become ubiquitous, gas prices would rise, every new electronic component would need a router, and every man in America would convince himself that little blue pills were the only things standing between him and a happily exhausted wife.

What about companies that barely existed in 1997? Google didn’t trade publicly then, and wouldn’t for years. Yahoo! did, at around $1. Each company’s profound growth remains invisible to the Dow.

Because the Dow regularly replaces its weaker components with stronger ones, its levels can mislead. Only if you own a Dow index fund – a basket of stocks that consists of equal proportions of Dow components, and whose makeup changes as the Dow itself changes – can you truly track that investment consistently over the years.

But because the Dow is measured in dollars, or at least a mathematical manipulation thereof, you have to account for inflation. The Consumer Price Index has risen 37% since February of 1997. (The Consumer Price Index is subject to biases of its own, but explaining them would require a few thousand more words.) The Dow itself has risen 43% in that same period. So in real dollars, a Dow index fund has appreciated .4% annually since then. Two-fifths of a stinking percent, and that’s ignoring broker fees. Should the Dow drop another 400 points – and it dropped half that much in the last 10 minutes of trading on May 23 – that’d wipe out every penny of those miniscule gains. That’s one term of Clinton, two terms of Bush, and a term-in-progress of Obama with no appreciable gain in the Dow.

Your conservative neighbor whose entire portfolio is 3-year CDs doesn’t look so stupid now, does he? Yes, it’s easy to look back with perfect eyesight, but there is such a thing as overdiversification. And while that’s never as dangerous as riding the waves with only one or two stocks, it does lower your ceiling. When you put your eggs in one gigantic uber-basket, you’re not giving undervalued, bargain stocks a fair chance to boost your portfolio.

At Control Your Cash we shudder at the idea of frequent and indiscriminate turnover. A stock is an investment, not a blackjack hand. But we also hammer one primary mantra: Buy assets, sell liabilities. Do that often enough and you can’t help but get rich. Overpriced Dow components (and other big companies) with poor fundamentals are almost always liabilities.

Greg McFarlane is an advertising copywriter who runs ControlYourCash.com and lives in Las Vegas and Lahaina – testament to the power of entrepreneurship. His new book, Control Your Cash: Making Money Make Sens is a loud and forceful financial primer for people in their 20s and 30s who know nothing about money. You can buy it on Amazon or BN.com. Reach Greg at greg@ControlYourCash.com.

One Comment »

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