Should I Keep an Eye on the “Dow”?

Any investors listening to the morning radio or turning on television during the week have heard the performance of the Dow Jones Industrial Average. The investing media pundits seem to go into a wild panic whenever it falls and rejoice whenever it rises. A popular question, though, is why?

The Origins of the DJIA

To understand what the Dow Jones Industrial Average (DJIA), which is known to many simply as “the Dow”, means, first, you have to know what it meant back when it began. The precursor to the Dow Jones Industrial Average started in 1896, and its purpose was to provide a measure of how the industrial economy was performing. To do that, it started with 12 companies.

"Fearless Girl" is a bronze statue of a small girl with her hands on her hips legs apart in a prepared and bold stance with the streets of New York city behind her.
Wall Street’s “Fearless Girl”

The American Cotton Oil Trust, which dominated the cotton oil industry, is now part of Unilever. American Sugar, which was the main producer of sugar for the United States with plantations in Puerto Rico and other Caribbean nations, was bought by Domino Sugar. American Tobacco, which was broken up by the SEC into multiple companies. Chicago Gas, which has now become Integrys.

Distilling and Cattle Feeding, which oddly enough produced whisky and had nothing to do with feeding cattle. General Electric, still exists today but was removed from the Dow in 2018. Laclede Gas was and still is a natural gas company in Missouri. The North American Company was a holding company with interests practically everywhere. National Lead, which was the biggest company in the lead-smelting industry. Tennessee Coal, Iron, and Railroad, which was a major mining and transport company. U.S. Leather was dissolved after antitrust lawsuits, and U.S. Rubber, jumped from owner to owner until it was bought by Michelin in 1990.

The bronze statue, Charging Bull, near wall street is quite famous. This image displays only a glimpse of the ready for battle bull's right eye, ear and massive horn and muscular shoulders.
Wall Street’s “Charging Bull”

These dozen companies spanned nearly the entire industrial sector of the United States, and that was the goal–to ultimately sum up the industry of the United States with an average. As companies fell apart, and new companies rose through the ranks, the Dow added and removed companies. In fact, none of the original 12 companies are on the current Dow, which is now comprised of 30 companies.

The Wall Street Journal

A more modern incarnation of the DJIA was first published in the Wall Street Journal in 1916. That index included 20 stocks–eight from the old index and 20 new stocks. In 1928, the index expanded to 30 stocks.

Today the Dow isn’t necessarily the most important measure of the stock market and the economy. With the rise of more indices, both broader and more specific, there are more ways to quantify the performance of the stock market and, more importantly, your own portfolio. The S&P 500 is an index of 500 stocks spread across the entire nation in various industries, and there are countless indices for specific sectors of the economy.

Does the Dow Do a Decent Job of Diversifying?

Throughout the entire economy of the United States, it is very difficult to create a thorough and complete picture of the economy with only 30 stocks. If your portfolio was heavily based in the automotive and oil industries, then the Dow wouldn’t really reflect your portfolio; the Dow does not currently include any stocks in the automotive or oil industries. Similarly, if your portfolio is based in companies outside of the United States, the Dow couldn’t represent your portfolio; all of the stocks in the Dow are based in the United States. That being said, almost all of the companies represented in the DJIA do have a worldwide business and could be affected by political factors.

The Dow

Ultimately, it is important to realize that the Dow, in most cases, doesn’t represent your portfolio. If you wake up one morning and see that the Dow has dropped 8%, your portfolio won’t match that exactly unless you are solely invested in a Dow Jones Industrial Average Fund. Because the Dow only represents 30 companies, the change in the price of one stock can drastically change the value of the entire average, while in indices like the S&P 500, it would take a much larger change in one stock to sway the entire average.

Noteworthy

Also worth noting, the Dow is what is called a price-weighted index. This means that the stocks with a higher trading price are weighted more heavily than the stocks with a low trading price. For example, Caterpillar(CAT) is currently trading at around $287.57, while Walt Disney Co (DIS) is currently trading at around $86.30. Even though the market capitalization of Disney is actually higher than the market capitalization of Caterpillar as of July 28, if the prices of both stocks were to increase by 2%, Caterpillar would have an impact on the index worth about three times Disney’s impact on the average. (Market capitalization is the value of all of a company’s shares of stock outstanding, and different companies have different numbers of shares of stock outstanding.)

Charles Henry Dow's portrait. A grainy black and white image of a man with a thick full dark beard. He is wearing a smart suit and large tie with a high white collar. Dark gazing eyes away from the camera. He appears to be thinking as he has his portrait commissioned.
Charles Dow
A Black and white man's portrait. He has a large curled mustache, receding hair-line, and a high white collared shirt under a heavy, fine suit.
Edward Jones

Who Created the Dow Jones?

And why is it called the Dow Jones Industrial Average? The index was first compiled and reported by two financial reporters, Charles Henry Dow, and Edward Davis Jones, who founded a company called Dow Jones & Co. The DJIA was only one of the indexes they created around that time; they also reported on an index comprised of 20 railroad companies which would later become the Dow Jones Transportation Index.

The NASDAQ

To sum it up, the Dow Jones Industrial Average has a really interesting history (if you’re into that sort of thing), and it gives an indication of the performance of a carefully curated selection of companies in the U.S. economy. However, it includes only 30 of the approximately 2800 companies trading on the New York Stock Exchange and 3300 companies on the NASDAQ. In addition, the DJIA only includes large company stocks. What does this mean to you as an investor? A large swing in the Dow probably doesn’t mean that your portfolio increased or decreased by the same percentage as the Dow. But, a large swing in the Dow is often indicative of significant events on the world stage.

This article is intended to be educational and thought-provoking rather than financial advice.  When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals.  During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.

BENEFITS TO HIGHER INTEREST RATES

By now, you’ve undoubtedly heard that “the Fed” has been raising interest rates to rein in inflation. Interest rates are an essential part of our economy, and their impact can be felt by nearly everyone who participates in financial activities. The federal reserve raises interest rates to restrict access to funds and hopefully slow down the rate of increase of prices, including wages, in the economy. While this sounds like an awful idea if you are a borrower or have used access to cheap money to grow your business, higher interest rates can positively affect savers and lenders. If you are a saver, higher interest rates mean you can earn more money on your savings. This can be really helpful if you are saving for a specific goal, such as buying a house, starting a business, or saving for retirement. With higher interest rates, your savings will grow at a faster rate, allowing you to reach your financial goals sooner. Another advantage of higher interest rates for savers is that they can help to combat inflation. Inflation is the rise in the cost of goods and services over time, and it can erode the value of your savings. In other words, if the prices of the goods you buy rise faster than the value of your savings, your savings can’t buy as many goods. However, if you are earning a higher interest rate on your savings, you can offset the effects of inflation and maintain the purchasing power of your money. For lenders, higher interest rates mean that they can earn more money on the loans they provide. This can be particularly beneficial for banks and other financial institutions that make a significant portion of their revenue from interest on loans. Higher interest rates can also encourage more lending, as lenders are more likely to provide loans when they can earn a higher return on their investment. And, when you purchase a bond, whether a government bond or corporate bond, you also become a lender and can benefit from higher interest rates. Retirees and others who live on fixed incomes are often savers and lenders—a large part of their income is often the interest generated from savings deposits and bond interest. After nearly a decade of extremely low interest rates, these new higher interest rates are a real boon to those living on fixed incomes. Another advantage of higher interest rates for lenders is that they can help to stabilize the economy.  When interest rates are low, borrowing becomes cheaper, and consumers and businesses are more likely to take on debt. However, this can lead to an increase in inflation and a potential economic bubble, and in some cases, poor management decisions. Low interest rates can allow a company which is either poorly run or may not have an economically feasible business model to continue operations simply by borrowing cheap money. By raising interest rates, lenders can discourage excessive borrowing and prevent an economic crisis. Higher interest rates will have a different effect on savers and lenders versus borrowers. Savers can earn more money on their savings, combat inflation, and reach their financial goals faster. Lenders can earn more money on loans, stabilize the economy, and prevent potential economic crises. While borrowers may have to curtail spending in order to accommodate the higher cost associated with borrowing. While there may be some drawbacks to higher interest rates, the benefits for savers and lenders are significant.

This article is intended to be educational and thought-provoking rather than financial advice.  When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals.  During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.

IMPACT OF HIGHER INTEREST RATES

While higher interest rates can be beneficial for savers and lenders, as we discussed in our last post, there are also several drawbacks to consider. In this blog post, we will explore some of the potential disadvantages of higher interest rates.

One of the most significant impacts of higher interest rates is that they can lead to increased borrowing costs for consumers and businesses. When interest rates rise, it becomes more expensive to borrow money, which can reduce consumer spending and business investment. This can lead to decreased economic growth, as businesses are less likely to expand and hire new employees. In fact, the employment numbers and wage levels are key economic indicators the Federal Reserve is using to determine when and the degree to which they should raise rates. 

Higher interest rates can also have a negative impact on the housing market. When interest rates are high, fewer people can afford to buy homes, which can lead to a decrease in demand and a drop in housing prices. This can be particularly problematic for homeowners who are looking to sell their homes for those who are in the process of buying a home. In some cases, it leads to consumers feeling “trapped” in their current homes because they currently have low fixed mortgage rates. Because mortgage rates are so much higher than they were just a few years ago, taking out a loan of the same size as the original loan to buy a new house can lead to a drastically higher mortgage payment.

Another potential drawback of higher interest rates is that they can lead to a decrease in the stock market. When interest rates rise, investors may sell their stocks and invest in safer, fixed-income securities such as bonds. This can cause a decrease in demand for stocks, which can lead to a decrease in stock prices. In addition, higher interest rates increase the price that businesses pay to borrow. Businesses that rely on cheap money (low-interest rates for borrowing), they may be unable to sustain the growth that they’ve had. And in some cases, a company may not be able to continue operations if the money it borrowed was subject to floating or variable interest rates and the payments have now simply become too large for the company to continue making payments.

Higher interest rates can also lead to an increase in the value of the currency. When interest rates rise, foreign investors may be attracted to invest in the country, which can cause an increase in the demand for the currency. While this may seem like a positive outcome, it can also make exports more expensive, which can harm businesses that rely on international trade.

Finally, higher interest rates can lead to an increase in the national debt. When interest rates rise, it becomes more expensive for the government to borrow money, which can lead to an increase in the national debt. This can have long-term consequences for the country’s financial health and can lead to a decrease in government spending on programs, including healthcare and education.

While higher interest rates can have benefits for savers and lenders, they also have several drawbacks to consider. These include increased borrowing costs for consumers and businesses, a negative impact on the housing market, a decrease in the stock market, an increase in the value of the currency, and an increase in the national debt. When considering the impact of higher interest rates, it is important to weigh both the potential benefits and drawbacks before making any financial decisions.

This article is intended to be educational and thought-provoking rather than financial advice.  When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals.  During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.

INTEREST RATES AND ECONOMIC CYCLES – WHAT’S IN IT FOR YOU?

Incident description

Interest rates and economic cycles–What’s in it for you? Economic cycles are characterized by alternating periods of expansion and contraction in the economy. These economic cycles can have an impact on interest rates, and, in many cases, the level of interest rates affects economic cycles. Right now, the federal reserve and other central banks have been raising interest rates in order to increase the cost of borrowing and hopefully slow down an overheating economy. As we discussed in our last two blog posts, there are benefits and drawbacks to individual consumers and businesses of these higher interest rates. Today, we’re going to look at how you, as a consumer, can set yourself up to take advantage of both high and low-interest rates. Not too long ago, interest rates were low–very low. If you purchased a home with a fixed-rate mortgage or perhaps refinanced a fixed-rate mortgage during this period, you might have borrowed at rates around 3%. Now, you can get 4% on your money just by leaving it in a savings account. And, after a year when the S&P 500 dropped about 20%, a 4% return sounds lovely. During those years of low-interest rates, finding places to get a decent return on your money with relatively low risk was difficult. When investing, we look for an appropriate risk-adjusted return; in other words, we expect a higher return if we take on more risk. Interest rates were so low that many savers became investors simply because they couldn’t get a decent return on their money by saving and lending. They had to take on more risk to get a decent return. And fortunately for them, we experienced the longest bull market in history from 2009-2020. With higher interest rates, you have to do more of a balancing act between investing in equities like stocks or lending like purchasing bonds or other debt instruments. In an ideal situation, you would have funds to deploy in each case as soon as the balance shifted such that your comfort level (your risk tolerance) could be met and your desired level of return could be achieved. However, we don’t have crystal balls and don’t know if any given economic event is a blip or the beginning of a new trend. As interest rates have increased over the last year, we’ve never known if we have already hit the top. If we’re at the top of the curve, then, as a lender or saver, you would want to lock in return for as long as you can.
On the other hand, if you lock in and then interest rates rise again the following week, you may be kicking yourself. Or, if you recognized that mortgage rates were at their lowest in 2020, you could have locked in a nice, low cost of borrowing for 30 years. At the same time, if you believe that we’re at the top of the curve, you also have to think about how long you think interest rates will be high. If you believe that interest rates will start dropping in the near future, then you may want to start investing again on the theory that easier money conditions will allow for accelerated business growth. The point here is that it is important to consider how economic cycles affect your individual financial situation. The “set it and forget it” method of financial planning may look like it works out for some folks. And, perhaps from a behavioral economic perspective, it has worked i.e.-they didn’t withdraw from their 401k because they weren’t thinking about their 401k. But, with a little attention, they may have been able to either reduce the risk in their portfolio or increase the return. Borrowing when the cost of borrowing is low–such as taking out or refinancing a mortgage–and lending when interest rates are high–such as purchasing treasuries and other bonds–is one method of taking advantage of the interest rates as we go through economic cycles.
Setting yourself up to make the most of interest rate changes is just one strategy you can use to reach your financial goals. Increasing or decreasing interest rates isn’t bad or good without context. It does come down to how you take advantage of them.

This article is intended to be educational and thought-provoking rather than financial advice.  When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals.  During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.