By R. Morris Coats

Closing at 10,006.78, this past Monday, the Dow Jones Industrial Average set a new record. An average of thirty blue chip stock prices (after accounting for various stock splits), the Dow has long been the barometer of the nation’s economy, measuring the day-to-day value of those thirty blue chip corporations. The Dow also gives us a good idea of the overall performance of the stock market, a market of speculators gambling on future stock prices.

Since the Dow is composed of the prices of quite several companies’ stocks, it helps to understand how each company’s stock price is determined. Like most prices, stock prices are set by supply and demand. Really, the stock market is not much different than the way odds are set at racetracks. Those who think a horse will do well in a race, bet on that horse, driving its odds up, while those who don’t like a particular horse bet on other horses, driving the odds down. When people expect that a company will perform well, they bet on that company, driving its price up. Those who think that other companies will outperform a particular company will dump the one they expect to come in at the rear and will buy stock in other companies or will do something else with their funds.

Many potential investors are afraid of stock market crashes, such as the one we had in 1929 that led up to the Great Depression, the deepest and longest recession this nation has seen. Stock market crashes are usually reversals of overly optimistic markets facing up to reality, the bursting of a "bubble."

Bubbles in the stock market occur when naïve investors dominate the market and invest by following the trend. If most of the investors (in dollars) buy a stock after a rise in that stock price, thinking that the price will go up further, a small initial increase in the price of a given stock will set off an upward trend that keeps on going. Eventually though, some investors will say "enough is enough," and begin to sell, starting a reversal of the trend.

While recent rises in the Dow have increased the proportion of naïve investors or trend followers in the market, the market is not dominated by such investors. Industry specialists who invest for various institutions and mutual funds dominate it. Institutional investors do not tend to get caught up in trends, but instead watch for stocks that have been bid up a bit by naïve investors and sell to them, keeping prices from being controlled by the naïve.

I am not saying that the stock market won’t crash. Instead, I am saying that such crashes are not as shattering as they once were. We had a crash this past August that brought the Dow from above 9300 to about 7500 in a few days. Instead of fueling further declines, the Dow quickly recovered and has far surpassed its previous high of last summer.

The stock market is a speculative market. Speculators tend to be right more than they are wrong. Otherwise, they lose their shirts and everything else and are driven out of the market, because they have nothing to speculate with. Speculators, when they are right, tend to do us all a favor. They move funds to those companies that can best use the funds and away from those who are destroying wealth by selling things that have less value than the resources it took to make them.

Speculators are prophets seeking profits. My favorite example of speculators is the story of Joseph and Pharoe in the Old Testament. After being thrown down a well by his jealous brothers, Joseph was sold into slavery and came to be an advisor of the Pharaoh. Tormented by a repeating dream, of seven fat calves followed by seven starving calves and seven full ears of grain followed by seven dried up, empty ears of grain, Pharaoh sought its meaning from Joseph, who had a knack for interpreting dreams. Joseph told him it meant that there would be seven years of bounty followed by seven years of famine. We all know what happened. Pharaoh bought grain and stored it during the seven years of good harvests and low grain prices and sold during the famine and high prices, and made a fortune. He also saved many lives.

The prices in the stock market are based on the collective wisdom and knowledge of the investing public and institutional investors. My advice: invest regularly in a diversified portfolio or in a diversified mutual fund and let the Pharoes and Josephs worry about the Dow.