Why The DJIA Has Outperformed Its Component Stocks Over Time

An important market event  will occur next Friday September 20, 2013.  The Dow Jones Industrial Average [DJIA] will perform its chameleon act and change its look.  Arguably the most important stock index in the United States (and maybe even the world) will once again renew itself.  3 of the current index components will be replaced by 3 other large capitalization stocks thought to be more representative of the United States economy.

The changes are as follows:

Bank of America (BAC)

 

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Hewlett-Packard & Co. (HPQ)

 

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and Alcoa (AA)

 

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will be replaced by Goldman Sachs (GS)

 

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Visa (V)

 

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and Nike (NKE).

 

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This ability to reconstitute itself is a big part of the reason that champions of the stock market often point to the ever rising index as proof that stocks in general will rise over the long term.

 

DJIA -- Long Term

 

The DJIA DOES rise over the long term.  With cheerleaders like:

  • the governing board (that determines the DJIA components)
  • the federal government
  • the FOMC
  • arguably the most innovative population (and business environment) on the planet and
  • an individual investor culture built on the premise of buying versus selling

the stocks which purportedly represent the United States economy would be hard pressed to decline over the long term.  And given that they would be switched out if they did decline over the long haul, the northern trajectory of the index is more or less assured.

That’s the good news…

The bad news (at least for those who trade individual stocks under the assumption that they will behave much like the index) is that all stocks do not benefit from the cheerleading squad above.  Individual stocks can (and do) fall out of favor.

If you trade individual stocks, make sure you have a sound, well tested strategy that includes good risk control and timing tactics.  Your results will be much better for it.