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WIKI ANALYSIS
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This article describes an index that measures the performance of an exchange, industry or a geographic region. View articles referencing this index. |
The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq. It is one of three major indicators of the movement of the U.S. stock market - the other two are the NASDAQ Composite and the Standard & Poor's 500.
Composition of the Dow Jones Index
The composition of the Dow Jones Industrial Average, as of September 22, 2008:[1]
Pros and Cons of the Dow as an Economic Indicator
Pro
- The Dow, invented by Charles Dow in 1896, is the second-oldest continuing U.S. market index.[2]
- It is one of the world's most-watched economic indicators, consisting of 30 of the largest and most widely held public companies in the United States.
Con
- Because the Dow is price-weighted, it gives higher-priced stocks more influence over the average than lower priced ones. A $1 increase in a $5 stock's value is a much larger percentage gain than a $1 increase in a $200 stock, for example, but both price changes affect the Dow in the same way.
- The Dow only includes 30 stocks, a very small sample of the thousands of companies that are publicly traded on U.S. exchanges.
How does the Dow Jones Index work?
Calculating the DJIA is not as simple as adding up the prices of the 30 stocks in it and dividing by 30. This is because of stock splits - if, for example, a stock trading at $50 dollars makes a 2-for-1 stock split, its shares would now be priced at $25. This would bring the price of the average down even though there was no fundamental change in the stock's value. To deal with this problem, the DJIA calculation is done using the Dow divisor.[3]
The Dow Divisor
To calculate the DJIA, add up the prices of the 30 companies in the index and divide by the Dow divisor. This divisor is constantly changing due to events like stock splits.
To illustrate how the Dow Divisor is used, let's create our own index of 10 stocks. These 10 stocks total $500 when their stock prices are added together - and to get the value of our new index, we divide the total price ($500) by the divisor (10) to give us an index value of 50 points.
$500/10 = 50 points
Now, one of our stocks (Stock A) does a 2-for-1 stock split. For the sake of the example, let's say that nothing else changed in our index - all the stocks remain at the same price, and Stock A that was trading at $50 is now trading at $25 after the split.
So our index total has changed - $475 - but our divisor must change as well to take the split into account - it becomes 9.5. So we divide $475/9.5 and get 50 points. The point value of our index hasn't changed, which makes sense because the fundamental value of all of our stocks hasn't changed either.
$475/9.5 = 50 points
How do Changes in Stock Prices Impact the Dow Average?
Translating a dollar change in one stock to a points change in the index is easy. Just divide the price change by the current divisor to get its effect on the index.
Let's use Stock A again, trading at $25. It goes up $5 - so we divide this by 9.5 to get .5 points. So a $5 increase in Stock A's price would add .5 points to the value of our index. If all else stayed the same, the index would go to 50.5 points.
An Example from the Actual Market
The Dow Jones Divisor, as of July 30, 2008, was 0.122834016.[4]
Dow component GE was up 2% on July 30 - $0.57 a share. So 0.57/0.122834016 = 4.64. The 2% rise in GE's stock price added 4.64 points to the Dow Average. The Dow was up 186.13 total points on July 30, as all but five stocks had percentage gains in their price on the day.[5]
$0.57/0.122834016 = 4.64 points
For more information, look at how stock indices work.
Further Reading
Fixing Dow Jones Index Flaws, Shoven & Sialm, 2/28/2000
References
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