The Dow is up, down, sideways?!

Time and again you hear on the radio or TV, the market is up 100 points, down 250, “hitting a ceiling at 13000″, or some other jargon — what does all this mean and should it mean anything to you?

Often the media refers to the Dow Jones Industrials Index when they refer to the stock market. I think this is very misleading, and serves their interests better than it serves the general public. Here’s why:

The “Dow” is a price weighted list of 30 arbitrarily chosen stocks that are supposed to represent the stock market. This price weighting means that McDonald’s has more influence on the index movements (recent price $56.05) than Microsoft (recent price $27.84) — even though Microsoft is a $265 billion dollar company and McDonald’s is a $67 billion dollar company by market cap. Strange isn’t it? There are several other problems with the index cited in this paper.

The index itself is very easy to calculate at various times throughout the day. This is why radio and TV loves it so much – it’s a catchy story to tell about the minute by minute changes in the “market”.

When the Dow Industrials Index was created over a hundred years ago it may have provided a good representation of market performance. Now that many investors have globally diversified portfolios in investments of various weights and market capitalizations — and are interested in total returns, the Dow should no longer be the benchmark of choice.

Rates of Return: Who’s counting what?

Many of you may remember the Beardstown ladies, a 14-member investment club from Beardstown, Illinois, who wrote books about how their common sense investing style made them amazing returns (see an old Time article on the subject).  It turns out their published 23.4% returns were actually 9.1% after an accounting firm audited their records!

Better yet, what about those cable shows called something like “Flip that house” where people claimed ten’s or hundreds of thousands of dollars in gains. 

Why aren’t people like us making that kind of money?!

I think there are many good take-aways from these examples but here are two: 1. Don’t trust rates of return people brag about; and 2. Most people don’t know how to calculate their actual rate of return. 

Let’s take a hypothetical house flipper who buys a run-down home for $200k, fixes it up with $60k over three months, then lists and sells the place in 90 days for $360k.  Sounds like an easy $100k doesn’t it?  You might say that’s a 38% return ($100k profit / $260k investment), but that’s not the entire picture.

Lets assume they put 20% down, get a great interest only mortgage rate pegged at 5%, pay closing costs of 7%, and pay cash for the upgrades.  Lets do the math and look at the cash flows:

1. In Jan, they pay $40k cash down payment, $20k house upgrades and interest of $667 ($160k loan * 5% / 12 months).
2. In Feb, they pay $20k house upgrades and interest of $667.
3. In Mar, they pay $20k house upgrades and interest of $667.
4. In Apr, they list the home for sale and pay the interest of $667.
5. In May, they pay the interest of $667.
6. In Jun, they sell the home for $360k, payoff the $160k mortgage, pay closing costs of $25k, and interest of $667.

That’s a rate of return of 12.63% (IRR), and if they did the same project for the next six months their annual rate of return is 25.26%.   A far cry from the 38% above however!

Hello world!

I often have many personal thoughts on financial planning issues and would like to share them — so I’ve created this blog as a means to record these little “nuggets” of information. My posts may eventually interest a variety of people and although I may mention issues relating to money and finance, I have no intention of ever including investment advice on this blog.

Cheers!