How stock indexes are rigged — and why that’s great for your clientArticle added by Patrick Kelly on January 10, 2012
Joined: September 22, 2011
Ranked: #32 (1,476 pts)
The word rigged is usually followed by the words lawsuit, loss or liability. But in the case of stock market indexes, I’m going to argue just the opposite, that rigged is indeed a term of endearment.
I’m sure the title of this article caused you just a little heartburn. I mean, rigged isn’t typically a consumer-friendly term. The word rigged is usually followed by the words lawsuit, loss or liability. But in the case of stock market indexes, I’m going to argue just the opposite, that rigged is indeed a term of endearment.
First, I must point out that I am not a stock market historian; nor will this article be an in-depth study of market performance. What this article is intended to do is introduce you to one powerful aspect of stock market indexes that may never have crossed your mind. It’s this: Unlike individual companies, stock indexes don’t fail.
Have you ever thought about that? Companies fail, but indexes don’t. While they may take massive losses from time to time, like we saw during the 1929 market crash and the 2008-2009 credit crisis, stock indexes are rigged to win in the long run. Let’s explore why this is the case by answering the three following questions.
1. How are they rigged?
To do this, let’s take a look at history — some recent, some older.
2. Why do they win?
3. Why is this great for your client?
The easiest way for us to explore exactly what I mean by stock market indexes being rigged is for us to look at a brief history of the Dow Jones Industrial Average. The Dow Jones Industrial Index was founded on May 26, 1896 by Wall Street Journal Editor Charles Dow. While the index is now comprised of 30 large publicly traded companies, many of the companies on the DJIA today having nothing at all to do with industrial production. That was not the case when it launched.
Below is the list of the 12 companies that comprised the DJIA on the first day of its official formation1 .
Does anything stand out to you about this list? If it’s not readily apparent, these two questions should help. How many of these companies are still in existence today? And, how many of these companies are currently still a part of today’s DJIA?
Though some were gobbled up in mergers, and others outright failed, only one of these original 12 names still finds itself on today’s DJIA listing — General Electric.
- American Cotton Oil
- American Sugar
- American Tobacco
- Chicago Gas
- Distilling & Cattle Feeding
- General Electric Company
- Laclede Gas
- National Lead
- North American
- Tennessee Coal, Iron and Railroad
- United State Leather Company
- United State Rubber Company
In fact, the DJIA components have changed 48 times since its introduction in 1896. Here is a sampling of the five most recent changes2:
As the saying goes, sometimes the only constant is change. How true that is. And when you look at the timing of some of these changes, you will begin to see what I mean when I say rigged.
- June 8, 2009 – Citigroup Incorporated and General Motors Corporation were replaced by Cisco Systems, Inc. and Travelers Companies.
- September 22, 2008 – American International Group Inc. was replaced by Kraft Foods Inc.
- February 19, 2008 – Altria Group Incorporated and Honeywell International Inc. were replaced by Bank of America Corporation and Chevron Corporation.
- November 21, 2005 – SBC Communications Incorporated was replaced by AT&T Incorporated.
- April 8, 2004 – AT&T Corporation, Eastman Kodak Company and International Paper Company were replaced by American International Group Inc., Pfizer Incorporated and Verizon Communications Inc.
In June of 2009, when Citigroup and General Motors were removed from the DJIA, both were in the throes of virtual meltdown. The market had just made a new low three months prior, and these two companies were hemorrhaging and on the verge of collapse.
Citigroup had gone from $557 per share in December 2006 to $10 a share in March 2009 (taking into account the 1:10 reverse stock split) — a 98.2 percent decline. And GM was nicknamed “Government Motors” because of the massive bailout. Quite frankly, at the time, neither was predicted to survive. I’m sure you remember.
As shown in just these five most recent changes, the operators of the DJIA remove companies they fear are in rapid decline or on the verge of eventual collapse. For instance, AIG replaced struggling Eastman Kodak in April 2004, only to later be removed after its own crisis in 2008.
And how are the companies for this index chosen? Here is an excerpt from an online article written by Joshua Kennon:
The editors of The Wall Street Journal decide which companies are included in the Dow Jones Industrial Average. There are no rules for inclusion, just a set of broad guidelines that require large, respected, substantial enterprises that represent a significant portion of the economic activity in the United States.3
In other words, it’s totally subjective. Stocks can be removed and replaced on the DJIA at any time in order to try to bolster the Dow’s results. Now, is this a bad thing? No … not if you’re an index investor. Think about it.
For example, AIG, which was once one of the most respected stalwarts in the financial industry, dropped from a split-adjusted price of $2,073.76 on Dec. 8, 2000 to a meager split-adjusted $7.00 on March 6, 2009 — a decline of 99.7 percent.
However, on Friday, Sept. 19, 2008, the last trading day before it was removed from the Dow, AIG was still trading at a split-adjusted price of $77; and just two short weeks prior to that, on Sept. 5, it was trading at $446.80. So, the decision to remove AIG from the index in September 2008 allowed investors to avoid the additional 90 percent loss that occurred as AIG plunged from $77 to $7 over the next six months.
So what’s the big difference between owning an individual stock like AIG and investing in a stock index? The difference is risk. AIG can, and almost did, go out of business — bankrupt, kaput.
In contrast, when the DJIA faces a company on the verge of collapse, they simply remove it from the index and replace it with a healthy company that will hopefully take the index to a new high. So you see, the DJIA is really not a fair indicator of stock movement or appreciation because it jettisons its losers and takes on new hopeful winners in order to show a continual march upward.
So now do you see why I say stock indexes are rigged? They really are. In the case of the DJIA, it doesn’t hold the same 30 stocks through thick and thin, till death do them part; rather, they continually tweak the index in order to try and show continual growth.
But, it is exactly this rigging that provides such a great tool for the consumer, at least those taking advantage of index investing. While individual companies can fall into bankruptcy, causing a stock investor to lose all of his or her money, a stock market index simply removes the cancer and replaces it with a healthy company, and the march upward continues.
This is a huge win for the index investor because the value of his or her account is tied to the index and not an individual stock that may or may not be in existence 20, 30 or 40 years from now. And quite frankly, with the pace of today’s change and technology, it’s impossible to predict which companies will survive from year to year and decade to decade.
But one thing is for sure, the index will survive; and therefore, so will your client’s portfolio.
And best of all, if you can help your clients take advantage of these rigged indexes through indexed universal life insurance and indexed annuities, which both guarantee zero losses in the negative stock market years, you have now revolutionized the traditional index investment strategy and provided your client with a game-winning grand slam.
Like I said, rigged isn’t necessarily a four-letter word. As a matter of fact, it’s not.
1Wikipedia - http://en.wikipedia.org/wiki/Historical_components_of_the_Dow_Jones_Industrial_Average
2Wikipedia - http://en.wikipedia.org/wiki/Historical_components_of_the_Dow_Jones_Industrial_Average
3Understanding the Dow Jones Industrial Average (DJIA) – A Beginner’s Guide to Understanding the Dow, Joshua Kennon –http://beginnersinvest.about.com/od/marketsexchangeindices/a/dow-jones-industrial-average.htm
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