Many people in the stock market attempt to predict the future using indices like the Dow Jones Industrial Average (DJIA). This index, which began in 1884 and now comprises 30 stocks, is often used to explain the value of long-term investing. However, since most of the original stocks have been replaced, comparing the early Dow to the current Dow is not meaningful.
Changes and Pitfalls of Stock Indices
Continuous Changes in Stocks
Only about 80 of the companies included in the S&P 500 index in the early 1950s were still included in the late 1990s. In the domestic market, only 7 of the top 100 companies in 1995 survived for over 50 years. Out of the top 30 companies by market capitalization in 1990, 12 disappeared within 15 years. This shows that the actual stock prices of the companies included in the index may not rise as much as the index itself.
Characteristics of the Dow Jones Index
The Dow Jones Index is calculated using a price-weighted method, meaning that stocks with higher prices have a greater impact on the index. For example, a stock priced at $100 has 100 times the influence of a stock priced at $1. Consequently, the Dow Jones Index can fluctuate significantly based on the decisions of the committee that selects the stocks included in the index. The Nikkei Index in Japan operates similarly.
Limitations of Analyzing Stock Indices
Changes in Included Stocks
Analyzing price-weighted indices like the Dow Jones or Nikkei can often lead to errors. When stocks are added or removed from the index, past chart analysis becomes irrelevant. Events like stock splits or issues with companies like AIG, GM, or Citigroup can drastically alter the index's course.
Market-Capitalization Weighted Method
To address these issues, indices such as Nasdaq, S&P, MSCI, KOSPI, and KOSDAQ use a market-capitalization weighted method. Most U.S. fund managers now benchmark against the S&P 500 Index. However, even this method is not flawless. The stock market index can vary greatly based on the trading activities of the included stocks.
Problems with Analyzing Stock Charts
An Illustrative Example
When people analyze stock charts like the Dow Jones or KOSPI, it reminds me of a story. Imagine a high school teacher noticing that his class's average score improves whenever top students transfer in before a mock exam. Conversely, the average score drops when these top students transfer out. Just as changes in student composition affect the class average, changes in the included stocks significantly impact the stock index.
Misguided Analysis
Attempting to analyze indices calculated using different methods, like comparing price-weighted Dow Jones and market-capitalization weighted KOSPI, exacerbates the problem. Seeing an expert apply the same indicators to both indices on TV is like watching a quack selling snake oil.
Conclusion
Analyzing stock indices is complex and often fraught with errors. Different indices like the Dow Jones, Nikkei, and KOSPI are calculated using various methods, making it unreasonable to analyze them in the same way. When investing in stocks, it is crucial to be aware of these limitations and approach analysis with caution.
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