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Archive for Sunday, October 7, 2001

10/7 Motley Fool

October 7, 2001

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Q: How is the Dow Jones industrial average calculated? -- I.R., Wausau, Wis.

A: The 105-year-old Dow Jones industrial average (DJIA), the oldest continuing U.S. market index, essentially represents the average stock price of its 30 component companies. (The companies include Walt Disney, General Electric, Microsoft, AT&T, Boeing, McDonald's, Coca-Cola, IBM, Eastman Kodak, General Motors and American Express, among others.) It probably seems like an unlikely average, though, at its recent 9,000, since none of the stocks is selling for anywhere near $9,000 per share.

On average, though, the shares actually would trade in the neighborhood of $9,000 -- if they had never been split, issued dividends, or undergone major changes such as spin-offs or mergers during the time they were listed in the index. To get from current stock price levels to the larger index number, a number called the "divisor" is used.

If IBM falls by 2 points, you just divide 2 by the divisor (which is adjusted frequently and was 0.14452124, last time we checked) and learn that this drop will decrease the DJIA by 13.84 points (2 divided by 0.14452124 equals 13.84). The overall average is calculated by adding up the stock prices of the 30 stocks, and then dividing by the divisor.

Q. What are "day" and "GTC" stock orders? -- F.F., Akron, Ohio

A: When you place an order to buy or sell stock with your broker, you have to specify, among other things, whether the order is good just for the day, or is good until canceled (GTC). GTC orders don't have an infinite life, though. They remain in effect until they're executed or canceled, or they expire. The lifetime expectancy of orders varies by brokerages and is typically one to three months.

THE FOOL SCHOOL

The Spread

When you go to your local used car dealer to unload your beloved 1991 Schnauzer 900ZX, the dealer will probably buy your trusty heap for fewer dollars than he plans to charge for it. That's understood; the difference is his profit. Wall Street has a similar dynamic, and it's called the "spread."

The spread is the difference between "bid" and "ask" prices. The bid is the price that someone is willing to pay to buy a security, while the ask is the price at which a security is offered for sale. On exchanges such as the New York Stock Exchange or the American Stock Exchange (and also on the Nasdaq), spreads for most stocks tend to be in the neighborhood of 1 to 10 cents per share. So while you might be able to buy Indoor Weather Patterns Inc. (ticker: FOGGY) for $32.40 per share, its sale price might be $32.48. That might not seem like a big deal, but for every 1,000 shares traded, it amounts to $80. On an average day, more than 3 billion shares are traded in the United States. If the spread for each were 5 cents, that would total $150 million. Per day. That ain't chicken feed.

Spreads serve as payments to those who keep the markets liquid -- brokerages and the market makers from whom we buy and to whom we sell shares of stock. Over the last few years, regulations and the move to decimal prices for stocks have helped decrease typical spreads. Still, it's smart to check what the spread is when buying or selling stock.

Be wary of wide spreads, as they're usually for volatile, infrequently traded or penny stocks, which can be extra risky. If a bid is $10 per share and the ask is $11, you're looking at a $1 spread, in this case equal to 10 percent of the bid. That means you start out 10 percent in the hole -- significant when you consider that the market only advances some 11 percent a year on average.

Spreads are inevitable, but you can limit their bite by not trading too frequently and by avoiding infrequently traded stocks.

My Dumbest Investment

Driven to Regret

Thirty-two years ago, college paid for, married and moving into a house, my wife and I found the need for a second car. We owned 300 shares of PennSquare Mutual Fund (now Federated American Leaders), then trading for $8.95 per share. We sold 100 shares and bought the car. Today, the remaining shares have grown in value to almost $200,000. Ouch -- that's one expensive used car! We sold it four years later for $200. -- G.C., West Lawn, Pa.

The Fool Responds: It's hard to avoid selling some investments on occasion, especially for large purchases. But it's useful to think twice or thrice before doing so, to make sure that the money will be well spent. Consider the alternative uses for the funds (investment vs. car vs. down payment vs. vacation in Tahiti, for example), and decide which use makes the most sense and which will serve you best in the long run.

Foolish Trivia

Based in New Jersey, I was founded in the United States in 1887 by Germans. My commitment to "university quality" research might have something to do with the Nobel Prizes won by some of my employees. My products include Vasotec, Propecia, Fosamax, Vioxx, Zocor, Cozaar, Hyzaar and Singulair. I've introduced 15 new medicines since 1995. A large chunk of my business is managing pharmacy benefits. I rake in more than $40 billion per year, employ roughly 70,000 people, and have more than a quarter of a million shareholders. I've long been named as an exemplary employer for working mothers. Who am I?

Last Week's Trivia Answer: I came to life in 1965, when my co-founders sold an accordion and a bicycle in order to buy their first knitting machine. I'm based in Italy, but you'll find my 5,000 retail outlets in 120 countries around the world. My colorful brands include Sisley, Playlife, Nordica and Killer Loop. My advertisements tend to be colorful, too, often causing controversies. In 2000, I tackled capital punishment. I produce 90 million items of clothing annually. Who am I? (Answer: Benetton Group)

THE FOOL TAKE

More Microsoft

Microsoft is not out of the government's woods yet and will still face some sort of penalty -- probably sooner rather than later, given the speed at which both parties want the antitrust case resolved. But the news that the harshest punishment is off the table is incredibly good for the company and its investors.

On the growth front, Microsoft is counting on the release of Windows XP, its next major operating system, to boost sales next year. The new operating system is not set to be officially released until Oct. 25, but computer and software retailers have recently begun taking pre-orders. Microsoft hopes the increased hardware requirements of the new operating system will drive people to upgrade their computers, which would be welcomed by the beleaguered sector.

Forecasts for PC growth this year and next aren't rosy, to say the least. But Microsoft isn't off-base expecting a recovery in the long run. We won't see consumers upgrading PCs as quickly as they used to, but Windows XP should help drive sales. Even with the recent slide in Microsoft's stock price, however, the company remains highly valued, which brings risk. Still, Microsoft is in the driver's seat and on the right path.

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