How to Beat the Dow
The Dow Jones Industrial Average, also referred to as the Dow, is one index used by investors to gauge the overall level of market return. The index was created by the co-founder of Dow Jones and Company, Charles Dow. Beating the Dow is synonymous with beating the general market, which is the holy grail for any investment manager.
- Difficulty:
- Moderately Challenging
Instructions
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1
Review the Jensen index, also known as alpha. Alpha is what every investor manager is in search of, as it represents how much a portfolio's realized return is over and above the general market. In this case, the Dow is used to represent average market return.
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2
Define CAPM, or the capital asset pricing model. This model is used to evaluate the return of an investment. CAPM provides a formula for measuring alpha and is expressed as follows: α = Rf + (Rm -- Rf) β, where α is alpha, Rm is market return, Rf is the risk-free rate, and β is beta.
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Let's work through an example. If alpha is a measure for how well a stock is outperforming the market, it can also be used as a proxy for how well a stock or portfolio is performing above the market.
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Determine the risk-free rate of return. This is generally assumed to be the rate on a U.S. Treasury bill or one-year risk-free asset; that is, it is the rate an investor pays to invest in a risk-free investment. For the purpose of this exercise let's assume the risk-free rate is 5 percent.
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Determine the Rm and beta. For this example the market rate is the Dow's. Let's assume the Dow, on average, has a market return of around 12 percent. Beta is a measure of market risk. You can look up the beta for a company on many financial websites, including Yahoo! Finance. After you input the ticker symbol for the company, look under the "Key Statistics" tab. As of October 22, 2009, the beta for GE was 1.65.
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Calculate alpha. In this example, alpha is .05 + (.12 -- .05) 1.65, which equals .1655, or 16.6 percent. This is greater than 12 percent (the Dow market return). So theoretically, and all other things being equal, GE is a stock that should beat the Dow in the long term.
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Tips & Warnings
Consult an investment adviser before making any investment decisions. Professional fund managers and investors do not always beat the Dow or any market index. There is no guaranteed way to beat the Dow--the information presented in this article is only a theory. Use extreme caution before investing any money in the stock market.
