Course 203: Understanding the News
The Dow Jones Industrial Average
In this course
1 Introduction
2 Stock Indexes
3 The Dow Jones Industrial Average
4 The S&P 500
5 The Nasdaq Composite
6 "Noise" Versus News
7 Negative Earnings Surprises
8 Analyst Upgrades/Downgrades
9 Newsworthy Events
10 The Bottom Line

Known as just the "Dow" for short, this index is not really an average, nor does it exclusively track heavy industry anymore. The index is composed of 30 large stocks from a wide spectrum of industries. General Electric (GE) is the longest-tenured constituent of the Dow, which has changed substantially over time. The latest change to the Dow was UnitedHealth Group (UNH) replacing Kraft Foods (KFT) in 2012. In 2009, former constituents General Motors (GM) and Citigroup (C) were replaced with Travelers (TRV) and Cisco (CSCO).

At the close of business on Oct. 26, 2012, the Dow stood at 13,107. How is this figure calculated?

The index is calculated by taking the 30 stocks in the average, adding up their prices, and dividing by a divisor. This divisor was originally equal to the number of stocks in the average (to give the average price of a stock), but this divisor has shrunk steadily over the years. It dropped below one in 1986 and was equal to 0.1302 in October 2012. This shrinkage is needed to offset arbitrary events such as stock splits and changes in the roster of companies. With the divisor at 0.1302, the effect is to multiply the sum of the prices by about 7.7. (The numeral one divided by 0.1302 is approximately 7.7.) To look at it another way, each dollar of price change in any of the 30 Dow stocks represents a roughly 7.7-point change in the Dow.

Because the Dow includes only 30 companies, one company can have much more influence on it than on more broad-based indexes. Also, since the prices of the 30 stocks are added and divided by the common denominator, stocks with larger prices have more weight in the index than stocks with lower prices. Thus, the Dow is a price-weighted index. It's also useful to remember that the 30 stocks that make up the Dow are picked by the editors of The Wall Street Journal, rather than by any quantitative criteria. The editors try to pick stocks that represent the market, but there's an inevitable element of subjectivity (and luck) in such a method.

Despite its narrower focus, the Dow tracks quite well with broader indexes such as the S&P 500 over the long run.

Next: The S&P 500 >>


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