| Answer: Dear Mr. Iorio:
An excellent question...even most pros don't know the precise answer to how the Dow is computed. (I asked several!) Let's start at the beginning.
WHAT IS THE DOW?
When a stock changes in price, the people who care most, of course, are its shareholders. But when the whole market moves dramatically up or down, everyone cares because it's a reflection of what's happening in our economy.
The market's activity is reported in various averages and indexes, the most well known being the DOW JONES INDUSTRIAL AVERAGE. (Others are listed at the end of this Under the Oak answer.)
THE BACKGROUND...
The DJIA was started by Charles Dow (co-founder along with Edward Jones of Dow Jones & Co.) in the late 1880's. He drew up a list of the average closing prices of 12 major stocks (primarily railroad companies) and divided them by 12. The official DJIA as we know it was launched in 1896 in the Dow Jones newspaper, "The Wall Street Journal." In 1928, the list was expanded to 30 industrial companies -- the number it has today. General Electric is the only one left from the original list.
TODAY...
The 30 large "blue chip" stocks in today's Dow are regarded as leaders in their industries, widely held by both individual and institutional investors. You'll note when you run down the list that there are no transportation or utility companies. That's because each group is tracked in a separate Dow Jones average.
HONEY, I SHRUNK THE DIVISOR...
The average itself is arrived at each day by adding up the prices of all 30 stocks and then dividing the total price by a divisor.
Originally, the divisor was equal to the number of stocks in the average, which was 12. But over time the divisor has shrunk to account for stock splits as well as spin-offs and dividends.
In 1986, for the first time, the divisor fell below 1, due to a two-for-one split by Merck & Co. The current divisor is listed in the "Wall Street Journal."
$TIP: If you love to crunch numbers and you'd like to study the official formula for the divisor, log on to: http://averages.dowjones.com/faqs.html.
THE DOW'S LIMITATIONS...
When the Dow is rising, it would seem logical to view this as an indication of a strong economy. Yet it's important to keep in mind that although the Dow consists of 30 well known stocks, it actually represents only about 25% of the total value of all the stocks listed on the NYSE and about a fifth of the $8 trillion+ market value of all U.S. stocks. (These percentages are approximate and keep changing, but I mention them to emphasize that the Dow is not the entire market.)
Another key limitation is that the Dow is "price-weighted." That means, higher-priced stocks have greater weight than lower priced stocks on the average. In other words, if a low priced stock moves up or down say 8%, it does not affect the Dow as much as an 8% move in a high priced stock.
Let's look at a specific example. When Citicorp and Travelers announced their merger back in 1988, the Dow jumped up nearly 50 points. However, 45 points of this gain was due to Travelers, one of the Dow components; it rose more than $11 based on the merger news.
The broader-based S&P 500, which is weighted by market capitalization, actually went down a point that day. So, on any given day, a major price fluctuation in just one or two high-priced stocks can exert a strong influence on the Dow's average.
WHERE THE 30 STOCKS COME FROM...
The 30 stocks that make up this influential index are selected by editors at the "Wall Street Journal." This is not a hot stock index and changes are rare. In fact, from May 1991 to March 1997 there were no changes. The editors do not use a statistical grid or a formula for picking stocks, although they obviously try to select ones that represent the market. Nonetheless, the selection process is to some degree subjective.
Some Dow detractors point out that it's light on "new world" stocks, including technology, biotech and internet companies. However, about a year ago, the editors added Home Depot, Intel, Microsoft and SBC Communications, removing Union Carbide, Goodyear Tire & Rubber, Sears, Roebuck and Chevron. (Sears had been in the Dow since 1924, Union Carbide since 1928, Goodyear since 1930 and Chevron since 1984.)
Despite these additions, many investors also watch other market indicators.
SPEAKING OF OTHER MARKET INDICATORS...
Among the most popular are:
- NYSE Composite Index: all common stocks traded on the NYSE (http://www.nyse.com/)
- Standard & Poor's 500 Index: follows 400 industrial companies, 20 transportation companies, 40 utilities and 40 financial companies. (http://www.standardandpoor.com/)
- The NASDAQ Stock Market Composite Index: follows stocks traded on the Nasdaq Stock Market. (http://www.nasdaq.com/)
- The AMEX Composite: follows companies listed on the American Stock Exchange (http://www.amex.com/)
- The Russell 2000: follows the performance of 2000 small companies. (http://www.russell.com/)
- The Wilshire 5000, follows all U.S. headquartered stocks with readily available price data; it includes over 7,000 securities. (http://www.wilshire.com/)
30 STOCKS DOES NOT A MARKET MAKE...
BOTTOM LINE: Even though the Dow is not a yardstick for measuring the entire stock market, (30 stocks does not a market make) you certainly should follow it. The fact that it's so widely watched means that it exerts a strong influence on the decisions made by individual and institutional investors.
But remember, a 100 point rise or dip when the Dow is over 10,000 is less meaningful than if the Dow were, say at 5,000.
$TIP: If you're now intrigued by the Dow and other benchmarks, click on the websites of each for in-depth details. |
