The Dow Jones Industrial Average is on the verge of hitting 20,000 points for the first time -- a major milestone. While most people have a general idea of what this means (the stock market is going up), the Dow's significance isn't well understood by many investors. With that in mind, here's how the Dow works, what the 20,000-point milestone represents, and what it means for your investment strategy.
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How does the Dow Jones Industrial Average work?
The Dow Jones Industrial Average, more commonly known as "the Dow," is based on the performance of just 30 companies, which often surprises newer investors since it's considered a benchmark index for the entire U.S. stock market.
Furthermore, the list of companies that make up the Dow changes from time to time. In fact, of the 12 original Dow components, only one (General Electric) is still in the index today. As of this writing on Jan. 3, 2017, here are the current components of the Dow.
- American Express
- Cisco Systems
- General Electric
- Goldman Sachs
- The Home Depot
- Johnson & Johnson
- JPMorgan Chase
- Procter & Gamble
- UnitedHealth Group
- United Technologies
- Walt Disney
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Another interesting characteristic of the Dow Jones Industrial Average is that it's a "price-weighted" index. Simply put, this means that higher-priced stocks have more of an influence over the index's performance than lower-priced ones. While the mathematics of how the Dow works can be a little confusing, let's consider one example.
As I write this, Goldman Sachs trades for just under $244 per share, while Microsoft trades for about $62.50. This means that a certain percentage move in Goldman Sachs's stock would have about four times the effect on the Dow than Microsoft, even though Microsoft is five times the size of Goldman, by market cap. In fact, during a recent trading day, the Dow was up by 70 points and it was reported that Goldman Sachs accounted for approximately 50 of it.
This is one of the biggest criticisms of the Dow. In contrast, the market-cap weighted S&P 500 places more weight on the largest companies, which many investors say is a far better way to gauge the overall performance of the stock market.
So, what will Dow 20,000 mean?
It's important for investors to realize that while seeing the Dow hit 20,000 for the first time will be a psychological milestone, it's really just an arbitrary number based on a strange method of combining the performance of 30 stocks. As my colleague Sean Williams pointed out a few weeks ago, there's no more reason to celebrate Dow 20,000 than any other number that was recently reached for the first time.
Besides, the market has an upward bias over the long term and 20,000 will be reached sooner or later, whether it's a month from now, a year from now, or before I'm even finished writing this. Historically, the Dow has increased by about 7% per year, so this means that since the Dow finished 2016 at 19,762, the historically based expectation would be for a level of about 21,146 by the end of 2017. In other words, it would be disappointing if the Dow didn't break through 20,000.
What to do after the Dow hits 20,000
The bottom line is that while you're likely to see headlines celebrating Dow 20,000, it shouldn't have any effect on your investment strategy.
Don't sell your stocks just because you think Dow 20,000 indicates that the market "has gotten expensive." If your original investment thesis still applies, there's no reason to exit any of your stock positions. Similarly, there could still be plenty of bargains to be had in the markets that are trading at low valuations, including some of the stocks in the "Dow 30." The index's value has no correlation with the valuations of any individual stocks.
The best advice I can give for Dow 20,000 is to keep your eye on the long term. Focus on building a portfolio of attractively valued stocks and holding onto them for years. This advice will also hold true at Dow 25,000, Dow 30,000, and any other index-related milestones that may be reached during your lifetime.
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Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Matthew Frankel owns shares of American Express, Apple, Caterpillar, and Goldman Sachs. The Motley Fool owns shares of and recommends Apple, Nike, Visa, and Walt Disney. The Motley Fool owns shares of ExxonMobil and General Electric and has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool recommends American Express, Chevron, Cisco Systems, Coca-Cola, Home Depot, Intel, Johnson and Johnson, UnitedHealth Group, and Verizon Communications. The Motley Fool has a disclosure policy.