Why Asset Class Investing

The first of a three part series

Part 1 – Stock Indexes – proxies for the Market (Dow Jones, S&P 500, Nasdaq)

Market Averages

Market averages of stock indexes (shares/equities) are like a batsman’s average at cricket or a goal kicker’s average at rugby – they measure historical performance over a period of time.  It allows interested parties to measure on a purely objective basis.  No personal feelings or opinions.  Factual.  Empirical.  This is important when it comes to investment just as it is when it involves sport – especially when it involves one of our own versus someone from a competing nation or province.  Financial analysts are human beings as are economists and stockbrokers, financial advisers and fund managers.  But a market average is uncontested.  It is the measure of securities from a chosen asset class (in this example – stocks) and a composite of their price (the Dow Jones Index) or their capital value (the S&P 500) divided by the number of stocks.  It is factual.

What I’ve learned from 40 years in the financial services industry is that a provincial bias in rugby has nothing on financial conviction with investment.  Whether at consumer/retail level for basic residential property investors or term deposit investors looking for income.  The vehemence of conviction and belief is seldom swayed by ‘the facts’.  Or at wholesale/supplier level where active fund managers and stock brokers maintain the mystique of ‘outperformance’ (alpha) against public perception and experience or academic evidence.

The Dow Jones Industrial average was created in 1896 in the US.  12 stocks originally and in 1928 increased to 30 stocks.  (Its present size.)  Six of the 12 companies have survived in much the same form (commodities – cotton, sugar, tobacco, lead, leather, rubber) but only one – General Electric, has maintained both its membership of the Dow Industrial Index and retained its original name.

The original Dow Index averages were simply the sum of the prices of the component shares divided by the number of stocks in the index.  However this divisor (the number of stocks) had to be adjusted over time to prevent jumps in the index when there are changes with companies i.e. stock splits.  The Dow Industrials is a price weighted index and now uncommon as the impact of a company’s stock price on the index is unrelated to the size of the company.  The Dow Industrial index remains a commonly quoted average, in places like NZ and is mistaken as a proxy for ‘the share market’.  In fact it only contains 30 companies and at the end of 2013 neither Apple nor Google were members.  The current Dow Index is 16,514 – an all time high, statistically available in all daily papers yet represents such a small (comparatively $4.5 trillion USD) number of US business.

In 1906 the Standards Statistics Co in US was formed and in 1918 began publishing the first index of stock values based on each stock’s performance weighted by its capitalisation or market value – instead of its price as Dow Jones did.  Capitalisation weighting is now recognised as giving the best indication of return on the overall market.  The Standard and Poors Composite Index was expanded to 500 companies in 1957 and became the

‘S&P 500 Index’.  At that time the value of the S&P 500 Index represented about 90% of the value of all New York Stock Exchange listed stocks.

As at the end of 2012 the total value of all S&P 500 companies was $13.6 trillion USD but this now represents around only 75% of the value of all stocks traded in US.  The S&P 500 soon became the standard by which the performance of institutions and money managers investing in large US stocks was compared.  Since its creation, the index has been continually updated by adding new firms that meet Standard and Poors criteria for market value, earnings and liquidity while deleting an equal number that fall below these standards.

On the 8^th of February 1971 the method of stock trading underwent a revolutionary change.  On that date an automated quotation system called the Nasdaq (an acronym for National Association of Securities Dealers Automated Quotations) linked the terminals of more than 500 market makers (dealers) nationwide to a centralised computer system.  At the time that the Nasdaq was created, it was clearly more prestigious to be listed with an exchange than to be traded on the Nasdaq however, the way quotes could now be disseminated (online) it made the process of investing and trading more attractive.  Many young Tech companies found the Nasdaq a natural home (Intel, Microsoft) and chose not to migrate to the NYSE.  The Nasdaq is a cap weighted index.  It was set at 100 from day one and took 10 years to double.  As tech stocks grew so too the Nasdaq.  At its peak in 2000 (the height of the tech stock bubble) the index reached 5,048 (10^th March 2000).  Today it stands at 4,161.

In 1959 the Graduate School of Business of the University of Chicago received a request from the brokerage house Merrill Lynch (ex John Key – somewhat after this date, but never the less a trader – albeit Forex).  The firm wanted to investigate how well people had done investing in common stocks.  The university built a database that could answer the question – dating from 1926.  This was to become the accepted database for academic and professional research.  The database currently contains all stocks traded on the New York Stock exchange, all American stock exchanges and the Nasdaq, nearly 5,000 stocks and a combined valuation of $19 trillion USD.

NB. For those following my blogs over the last few years will notice 1926 as the starting point for US data – that is why.

Next week.  Sectors within the indexes, and the NZX 50 Index.  An all time high?

The information provided in this blog is not intended to be a substitute for professional advice. You may seek appropriate personalised financial advice from a qualified professional to suit your individual circumstances.