Diversification <> Balanced

My apologies for this post, since it is a little deviation from my prior ones. But if you are like me, you are a bit schizophrenic and follow more than one topic.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. Diversify is the key word from from Cramer, Orman, Wong Ulrich to your local financial adviser. The inexes, 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 today Feb 23th, 2009 as follows:AA 5.81AXP 12.15BA 34.46BAC 3.91C 2.14CAT 25.12CVX 62.94DD 18.91DIS 16.97GE 8.85GM 1.77HD 18.71HPQ 29.28IBM 84.37INTC 12.08JNJ 53.65JPM 19.51KFT 22.96KO 42.09MCD 53.87MMM 45.41MRK 27.88MSFT 17.21PFE 13.27PG 48.9T 22.68UTX 42.35VZ 27.85WMT 48.88XOM 69.3So the DOW's pathetic 11-year low is calculated as follows:(5.81+2.15+4.463.91+2.14+25.12+62.94+18.91+16.97+8.85+1.77+18.71+29.28+84.37+
12.08+53.65+19.51+22.96+42.09+53.87+45.41+27.88+17.21+13.27+48.9+22.68+
42.35+27.85+48.88+69.3)/ 0.1255527090 = 893.28 / 0.1255527090 = 7114.780773.
Besides wiping down 11 years of "growth" it has done something more important: some components are more important than others because they have lost less.If you compare the influence of IBM vs. Citicorp (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: IBM 9.44%XOM 7.76%CVX 7.05%MCD 6.03%JNJ 6.01%PG 5.47%WMT 5.47%MMM 5.08%UTX 4.74%KO 4.71%BA 3.86%HPQ 3.28%MRK 3.12%VZ 3.12%CAT 2.81%KFT 2.57%T 2.54%JPM 2.18%DD 2.12%HD 2.09%MSFT 1.93%DIS 1.90%PFE 1.49%AXP 1.36%INTC 1.35%GE 0.99%AA 0.65%BAC 0.44%C 0.24%GM 0.20%
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.
The S&P is a market cap weighted average so its calculation is different.
But these two are topics for a follow up post. Enjoy.