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Diversified is not necessarily balanced
March 19, 2009
I have been following my retirement funds and other investments,
but then again who isn't, looking for ways to re-balance to get ready for the
(hopefully) imminent rebound. Diversification is the key word from Cramer, Orman,
Wong Ulrich to your local financial adviser. The indexes, major indicators, or
SMIS (Security Market Indicator Series) like the Dow Jones Industrial Average
(DJIA) or S&P500 are a sure way to diversify since buying into them means
buying 30 or 500 companies from technology to financials to automotive (good
luck with the last two). That is fundamentally correct. However, the way the
index is calculated is the trick, especially in times of turmoil like the
present.
According to Forbes' Investopedia (http://www.investopedia.com/articles/02/082702.asp ) the Dow is a price-weighted
index which means that it gets calculated by simply adding up the price of each
of the 30 stocks divided by a "constant" called the Dow divisor. For those of us
that are geeky its current value is 0.1255527090.
For example, according to
Yahoo Finance (http://finance.yahoo.com/q/cp?s=%5EDJI) the 30 DOW components closed on Feb 23th, 2009 as follows:
So the DOW's pathetic 11-year low is calculated by adding all these stock prices and dividing by 0.1255527090 = 7114.780773.
Besides wiping down 11 years of "growth" it has done something more
relevant: some components are more important than others because they
have lost less.
If you compare the influence of IBM vs. Citigroup (C), the former at
84.37 and the latter @ 2.14 (after an almost 10% rally, mind you) you’ll see
what I mean. A 10% gain in IBM will mean around 0.94% in the Dow whereas a 10%
gain in C will only mean a 0.024% in the DOW. in other words, C needs a 417%
rally to have the same effect as a 10% IBM gain. If the bailout can pull that
off ... well you get my point.
Diversified? yes, balanced? I think not. If
you are curious, as I am, a DOW index has the following weights on February 23rd.:
o
Is there a good strategy for balancing this best? you'd think so,
since financial and automotive have been hammered, they have been sent
to the bottom of the list. Now let's think what tha means for your
investment. For simplicity, let's create a hypothetical nonexistent
date where all 30 stocks' prices open at $10, the DJIA will be at 2389
(let's pray it is not in the future). Two investors with $3000 each
decide to invest in the DJIA that day. Investor A buys an index fund
that follows the DOW and buys 125.55 shares at $23.894 each. Investor
B buys 10 shares of each of the 30 companies. If both remain invested
that way until Feb 23, 2009 they both now have $8932.80. Investor A
still has 125.55 shares at $71.115. Investor B now decides to
rebalance her portfolio to hold equal dollar amount per share. The new
portfolio will look as follows:
 We now move to March 13 ,2009 where the DOW closed @ 7223.98.
Investor A will still have 125.55 shares, now at 72.24 or $9069.70.
Investor B however has $350.56 more with a portfolio that looks like
this:
Why? Because she sold high to buy low; the first rule of
investment. She still gets dividends and she is still invested in blue
chips (not quite a warranty these days) and she is exposed to a similar
risk. Of course this case is hypothetical and has conspicuously
ignored trading fees that will more than wipe $350 with at least 40
trades. But I think it illustrates the point.
The S&P is a market cap weighted average so its calculation is
different but the principal still applies, of course planning to trade
all 500 shares will be cumbersome, expensive, and perhaps stupid.
Enjoy
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