Tuesday, September 30, 2008

Points, Percentages, and Stock-Market Plunges

Monday’s stock-market plunge brought plenty of headlines like this: “Dow plummets record 777 as financial rescue fails.”

That was from the Associated Press. The article’s subhead said, “Dow dives 777 points, biggest single day fall ever, as House rejects financial bailout package.”

The “biggest single day fall” sounds more dramatic and newsworthy than the “18th biggest single day fall.” Yet they are both true for Monday: By points, it was the largest single-day fall; by percentage, it was only 18th.

If these rankings are both true, can one be truer? I’d say yes if “truer” means a fairer comparison.

Let’s start with an axiom: If you are comparing daily changes to the Dow over the time frame “ever”—as in “biggest single day fall ever”—you should consider every trading day since the Dow’s inception.

The Dow debuted in 1896 at 40.94 points. It did not reach 777 points until the 1960s. So if you compare Monday’s drop to the past using points, you effectively eliminate from consideration any day before then—and, from a practical point of view, most days until the very recent past.

Too bad, because eight of the ten largest percentage drops occurred before 1935. The Great Depression years account for five of them, but the all-time winner for percentage losers is December, 12, 1914, when the Dow lost more than 24%. [Update: While technically true that the Dow lost more than 24% that day, it turns out this was due to a recalculation of the Dow, not a plunge of the overall market. The Wall Street Journal’s “The Numbers Guy” explains.]

A close second is 1987’s Black Tuesday, when the Dow lost 22%. But even with that relatively recent event, 22% of the Dow was only 508 points then. In contrast, yesterday’s drop was around 7%, less than a third of Black Tuesday by percentage but 219 points more.

So, to the issue of fairness, it’s not fair to compare point changes when the point scale is different, as it is with a Dow of 40 points versus a Dow of 10,000 points. In contrast, percentages can factor-out the magnitudes of different point scales, thus making changes more comparable.

2 comments:

  1. Not to mention that the Dow Jones Industrial Average is calculated on a price-weighted method and that the companies included in the DJIA have changed over the years.
    Everything is a moving target.
    Side note: the DJIA only represents 30 companies. Is it really enough of a data set to be statistically significant?
    Sure, its emotionally and perceptively significant - but statistically significant of the entire market?

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  2. Isaac,
    Because the Dow covers a relatively small number of large companies, it is not as representative of the entire market as, say, the S&P 500.
    -Steve

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