Do a Google image search for "rich woman", and for some reason this picture of Malcolm Gladwell comes up

Welcome to Recycle Friday, in which we dig up the carcass of a vintage guest post of ours and see how it stands up in the modern era. Today’s originally ran on 20sMoney last year. Annotations in CYC maroon:

Today’s happy headline (“Your mutual fund is hurting worse than you think”) necessitates a little look back. How does today’s Dow Jones Industrial Average compare to, say, the Dow of February 1997?

Answer: It doesn’t. Sure, the average is 10,192 today (12,069 this morning, baby! The proverbial gravy train with biscuit wheels! Start borrowing!) and was around 6900 twelve years and 3 months ago, but…the average of what?

The Dow is the sum of the prices of 30 of America’s largest stocks, multiplied by a constant. But the roster of stocks itself isn’t constant. Here are some of the blue chips that comprised the Dow in ‘97:

General Motors
Citigroup
AIG

(This is already reading like a list of notorious contemporary eradications. Despite where we appear to be heading, the next items on the list are not the Seattle SuperSonics, the French franc and Lindsay Lohan’s career.) (Those semi-pop culture references still hold up, kind of. Maybe we could trade out Charlie Sheen for Lindsay Lohan, but that’s it.)

Altria
Honeywell
Eastman Kodak
International Paper
AlliedSignal
3M
Goodyear
Sears Roebuck
Union Carbide
Bethlehem Steel
Westinghouse
Woolworth

That’s almost half the then-Dow, consisting of the infamous and the doddering. Today, these names sound as though they belong in some bygone epoch of American proto-commerce. (Woolworth, if you’re interested, took scarcely more than a generation to fall from five-and-dimes with lunch counters that wouldn’t serve black people to sneaker retail. The company shed all its fat and kept its one legitimate asset, which is now its successor company – Foot Locker.)

So yes, the Dow has “risen” 60% since the cloning of Dolly the sheep. But that’s comparing today’s Dow to something that no longer exists. A basket of 1997 Dow stocks wouldn’t have risen anywhere near 60%:  a lot would depend on whether you used your General Motors certificate to make a paper airplane out of or wipe up kitchen spills with.

(Since then, General Motors made a comeback of sorts. The old shares were indeed rendered worthless, thanks to a federal government that decided that GM’s bondholders and owners didn’t matter as much as its employees – or more importantly, its employees’ union bosses. The new shares began selling on November 18 at $34.19. Fortuitously, they just happened to have dropped a record 5% yesterday to close at $33.02. Did we mention that your tax dollars are responsible for this? We did.)

(No Dow stocks have changed out since Cisco and Travelers joined in 2009. In fact, none of the current 30 are even in trouble.)

Conversely, if you’d had the foresight to invest in stocks that were to become Dow components –Verizon, AT&T, Chevron, Cisco, Intel, Pfizer et al. – you’d have enjoyed a lot more than a 60% return over 12 years. But you’d have had to predict that cell phones would become ubiquitous, gas prices would rise, every new electronic component would need a router, and every man in America would convince himself that little blue pills were the only things standing between him and a happily exhausted wife.

What about companies that barely existed in 1997? Google didn’t trade publicly then, and wouldn’t for years. Yahoo! did, at around $1. Each company’s profound growth remains invisible to the Dow.

Because the Dow regularly replaces its weaker components with stronger ones, its levels can mislead. Only if you own a Dow index fund – a basket of stocks that consists of equal proportions of Dow components, and whose makeup changes as the Dow itself changes – can you truly track that investment consistently over the years.

But because the Dow is measured in dollars, or at least a mathematical manipulation thereof, you have to account for inflation. The Consumer Price Index has risen 37% since February of 1997. (And 1.4% annually since this post first ran. Are we ever going to see the hyperinflation we’ve been anticipating?) (The Consumer Price Index is subject to biases of its own, but explaining them would require a few thousand more words.) The Dow itself has risen 43% in that same period. (See above.) So in real dollars, a Dow index fund has appreciated .4% annually since then. Two-fifths of a stinking percent, and that’s ignoring broker fees. Should the Dow drop another 400 points – and it dropped half that much in the last 10 minutes of trading on May 23 – that’d wipe out every penny of those miniscule gains. That’s one term of Clinton, two terms of Bush, and a term-in-progress of Obama with no appreciable gain in the Dow.

(The changes since then amount to a rounding error. Seriously, it’s up to an annual increase of 1.8%. Maybe things really are looking up, if by “things” we mean “stocks” and by “up” we mean “harder to buy”.)

Your conservative neighbor whose entire portfolio is 3-year CDs doesn’t look so stupid now, does he? Yes, it’s easy to look back with perfect eyesight, but there is such a thing as overdiversification. And while that’s never as dangerous as riding the waves with only one or two stocks, it does lower your ceiling. When you put your eggs in one gigantic uber-basket, you’re not giving undervalued, bargain stocks a fair chance to boost your portfolio.

At Control Your Cash we shudder at the idea of frequent and indiscriminate turnover. A stock is an investment, not a blackjack hand. But we also hammer one primary mantra: Buy assets, sell liabilities. Do that often enough and you can’t help but get rich. Overpriced Dow components (and other big companies) with poor fundamentals are almost always liabilities.

(Fortunately, Dow Jones Inc., the folks who determine which stocks comprise its bellwether index, have gotten a little more pragmatic lately. A company’s history, or its influence of a couple generations ago, is no longer as important as what it’s done for us lately. Maybe those fancy semiconductors and software really are here to stay.)

**This post is featured at the Totally Money Carnival #9-Funny Baby Videos Edition**