Dow Breaking New Records, Part 2

NEW YORK (Fortune) — You’ve got to love the stock market. Just about 10 days ago – on July 19, to be exact – the Dow Jones industrials closed above 14,000 for the first (and so far only) time and the financial world was full of happy chatter.

Then, almost before you could catch your breath (or cash in your profits), we had last week, with the Dow dropping 585 points and the total stock market (as measured by the Dow Jones Wilshire 5000) losing a cool $1 trillion in value. One day, the sky’s the limit. The next day, the sky is falling.

How is a retail investor – which most of us are – supposed to think about this? I’ve been writing about markets and playing around with stocks for close to 40 years, but I have no clue where the market will go next.

I do know two things, however. First, that the worst way to invest is to buy when optimism fills the air like it did two weeks ago, and to sell out when everyone’s predicting the end of the world, like last week. If you do that, you get whipsawed by buying dear and selling cheap.

The second thing I know is that you shouldn’t freak out when you see triple-digit moves in the Dow, either up or down. As the market has climbed over the past 20 years – the first triple-digit Dow move came in October, 1987 – a 100-point move has become less and less significant because the overall market is so much higher than it was.

Consider, if you will, the table at the bottom of this page, whipped up for me by the folks at Aronson+Johnson+Ortiz, a Philadelphia money management firm. As you can see, three-digit moves, once rarities, have become relatively common. You can also see that 100 points means progressively less in percentage terms – and to be an intelligent investor you need to think in percentage terms, not react viscerally to triple-digit Dow moves.

Let me show you how little 100 Dow points mean, by explaining how Dow Jones determines the Dow number. The Dow’s an arithmetic average, which you calculate by adding up the prices of the 30 Dow stocks and dividing the sum by the "Dow divisor." As of Friday, that wonderfully-precise number, which changes frequently, was 0.123017848. (Some day, I’ll tell you how Dow Jones determines the divisor. But this isn’t the day.)

This means that a $1 change in any Dow stock moves the average by about 8.13 points (that’s 1 divided by the divisor). So if the average price of all 30 issues changes by 42 cents – which isn’t much – you get a three-digit move in the Dow. (Want to verify that? Multiply 0.42 by 30, then divide the product, 12.6, by the Dow divisor. Isn’t this fun?)

To give you another example of how drops that are big in absolute terms aren’t all that big in relative terms, consider the Dow Jones Wilshire 5000. The 5K, the most accurate measure of the overall U.S. stock market, includes all U.S. stocks, rather than just the 30 Dow industrials or the 500 in the Standard & Poor’s 500 index.

On Wednesday, when the Dow dropped a sickening 311 points (its 16th-biggest one-day point drop ever), the Wilshire racked up its 18th biggest one-day drop in points – but only the 90th biggest drop in percentage terms.

One way to protect yourself against Dow Freakout is to have assets other than stocks in your investment portfolio. During rapidly-rising stock markets, like the bull market that started in October of 2002 and that I think ended last week, money funds and high-quality bonds drag down your overall performance because they return much less than stocks do. But they protect you during a declining market.

If you bail out of stocks entirely because of the Dow’s down days, you run the risk of missing the next bull market. Which will come sooner or later. So when will I be writing a piece warning you not to get carried away by the Dow’s triple-digit gains? Beats me. If I knew that, I’d be a professional investor, not a professional writer.