The Dow Jones Industrial Average is in the headlines everyday, but few people actually understand how it's calculated. The DJIA is the sum of the value of one share of each of the 30 Dow components divided by the DJIA divisor, which is currently 0.1255527090. It's adjusted every now and then for spin-offs, dividends and splits. For geeks, the image at right shows the formula: p equals the price of the shares and d equals the DJIA divisor.So what exactly is wrong with this formula? A ton. Critics have been pointing out forever that weighting the average based on stock price makes no sense because different companies have different numbers of shares outstanding. For example, if Berkshire Hathaway (NYSE: BRK.A) were part of the DJIA, its $70,000+ share price would dwarf the influence of all the other components combined. It would make much more sense to use a more holistic measure like market cap or enterprise value.
But the collapse of companies like Citigroup (NYSE: C), General Motors (NYSE: GM) and Bank of America (NYSE: BAC) has critics lobbing another allegation: Basically, as the share prices of these stocks decline, the influence they have on the DJIA shrinks too. For example, there are currently five stocks that are part of the Dow 30 that are trading below $10 per share. If all five went to 0, the Dow would fall by less than 200 points according (subscription required) to the Wall Street Journal.
Of course, it doesn't make any sense at all: If 1/6th of the companies in the Dow 30 going to 0 would cause the market to fall by less than 3%, it really can't be called an accurate barometer of the health of the market. The DJIA formula seems to substitute ease of calculation and simplicity for substance and value.
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Reader Comments (Page 1 of 1)
2-23-2009 @ 10:22AM
beanspants said...
you could force the dow to change their methodology....or you could just look at the S&P 500.
i mean, you have to turn a page or maybe click an extra button (fine for blogging stocks to see the rest of the article but way too much effort on yahoo; whatever) but you can do it.
2-23-2009 @ 10:39AM
Patriot said...
DJIA ? All I have to do is squeeze my wallet andi know how the economy is doing !Not much to squeeze!
2-23-2009 @ 9:00PM
joe harris said...
how is the s&p 500 calculated differently?
2-23-2009 @ 1:23PM
thedude said...
Personally I don't see how their calculations even matter. If the stock market as a whole was a $5 bill the DJIA wouldn't even be a penny, the S&P 500 would be two quarters and the S&P 1500 would be $1.50
I have always wanted to put together the 5000, and average the ups and downs of 5000 stocks on a daily basis.
I know the theory is that these collections reflect the overall health of the market but quite frankly I can't remember the last time I limited myself to these listings.
Everytime I talk to him my 7 year old father is always saying "Oh no the Dow is down, I'm getting killed !" to which I reply "Don't worry dad I'm already up 6% this year and its not even March yet"
The saying goes - Don't put all your eggs in one basket, live that advice and don't put all your money in one index.
2-23-2009 @ 3:24PM
beanspants said...
thedude,
just take the Russell 2K and the iShares MSCI EAFE (europe, austrailasia, far east), and you've basically got your index.
2-23-2009 @ 4:19PM
tmwwmgkbh said...
Jesus, you're a moron. Why do you think they change the divisor??? TO COMPENSATE FOR THE NUMBER OF SHARES!!! If you kick out Citi and introduce Berkshire, you change both the numerator (by the price change) and the denominator (by the number of shares change). The value of the DOW ends up being exactly the same after the switch. How does this help? Besides, the DOW is just one metric, you want something different? Look at the S&P 500... I think you'll find it looks oddly similar to the DOW.
2-23-2009 @ 7:35PM
RobertCharlesDobson said...
Well the S&P and NasDaq are doing better. How?
2-27-2009 @ 10:39AM
cpviolator said...
No, it does actually make perfect sense that a decline from $5 to $0 is treated the same as a decline from $15 to $10 or from $105 to $100 - because it's the SAME DECREASE IN SHARE VALUE. Is this too difficult to understand?
The thing about Citi, GM, BoA is: they've already taken the Dow way down by slumping to their present pitiful levels. If they were to fall to zero tomorrow, the financial hit would be TINY in comparison with what's already happened. The fact that the Dow is still at 7000+ despite the abject failure of 5 of its components shows that the other companies are holding up better. Anyone with half a brain would have moved out of Citi months ago...
The Dow is not 'a barometer of the health of the market'. (Since when did you use a barometer to measure your health?) It's a measure of how much a few shares are worth. Full stop.
2-28-2009 @ 2:16PM
Paul St. Amant said...
I don't see what the big deal is. As flawed as the DJIA is in theory, it tracks close enough with the S&P 500 and I hardly every hear the one mentioned without the other.
Paul St. Amant
www.softomic.com