NEW YORK (CNN/Money) -
I was wondering: How is the Dow Jones Industrial Average computed?
-- Fred Kolano, Grand Junction, Colorado
I'm tempted to say, "not very well," although I don't want to be hard on a venerable stock-market benchmark that's been around for more than a century.
Still, things have changed a lot since Wall Street Journal co-founder Charles Dow began computing his index in 1896 to track the industrial sector of the American economy. The basic methodology of the Dow, on the other hand, really hasn't fundamentally changed, which makes it a frequent target of index purists.
A small sampling of companies
One of the Dow's "flaws," if you will, is that it consists of just 30 stocks. Granted, it's a fairly diversified group, including industrial firms (Caterpillar), financial services (American Express), tech companies (Hewlett-Packard and Microsoft) and health care (Merck, Johnson & Johnson).
But there's no way that 30 stocks can accurately represent the entire U.S. market. In fact, I don't think even the Standard & Poor's 500 with its, uh, 500 stocks, is as good a proxy for the U.S. stock market as, say, the Russell 3000 index or the Wilshire 5000.
The Dow's other major shortcoming involves the way it's computed. Most indexes today, including the S&P 500, the Russell 3000 and the Wilshire 5000, are market-cap-weighted -- that is, the larger a stock's market value, the greater the weight its performance gets when calculating the index's return.
This makes sense because companies with larger market caps represent a larger share of the money invested in the market, and tracking the market really comes down to tracking where investors have put their money.
But the Dow is a price-weighted index, which means each company's weight in the index is based on its share price. To arrive at the level of the Dow, you add up the share prices of the 30 stocks and then divide by the "divisor."
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When Charles Dow started the index with 12 stocks in the late 19th century, he added up the shares and divided by 12. Today, because of various changes in the index over the past 106 years, the divisor is actually less than one, which means it acts more like a multiplier. (You can find the divisor, which was recently reset to 0.14585278 on page C2 of the Wall Street Journal every weekday, or you can get it at their Web site if you are a subscriber.)
This price-weighted methodology means that the ups and downs in a stock like 3M, with a recent share price of $127, affect the level of the Dow more than twice as much as the ups and downs of Microsoft, which recently traded at about $55 a share. That makes little sense since the market value of Microsoft, at roughly $293 billion, is nearly six times the $50 billion market cap of 3M.
But the Dow has its virtues, too
Despite all these shortcomings and the wailing of index purists, the Dow continues to be the index people think of first when it comes to tracking the market.
And, I have to say that, while I still think indexes like the S&P 500, Russell 3000 and Wilshire 5000 are better benchmarks for the broad stock market, the Dow has its virtues. Because it's so well known and referred to so often, it's easy to follow. And because it's been around for such a long time, it comes in handy for making long-term historical comparisons.
While it doesn't always track the overall market in the short-term -- the Dow is down a bit more than 15 percent so far this year, while the S&P 500 is down more like 22 percent -- over the long term it tends to follow the broad market indices.
In the final analysis, I guess the Dow is kind of like the "qwerty" typewriter keyboard. We know there are better alternatives. But it does a good enough job so that most of us will just continue using it.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He can be seen regularly Monday mornings at 7:40 am on CNNfn.
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