Figuring out the Dow

(Money Magazine) -- Question: How can I compute the Dow Jones Industrial Average on my own each day? --Sam Cordova, Los Angeles, Calif.

Answer: I'm not quite sure why you feel the need to do this. The Dow Jones Industrial Average is probably the most widely followed stock benchmark in the U.S., if not the world, and thousands of websites monitor it each trading day. Unless you subject yourself to a total news blackout, it's practically impossible not to hear the closing level of the Dow each day.

• Email
• Print
• Comment

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

Ultimate Guide to Retirement

• Getting started
• 401(k)s & company plans
• Investing
• Annuities
• IRAs
• Self-employment plans
• Pensions and benefit plans
• Social Security
• Insurance
• Estate planning
• Living in retirement
• Getting help

That said, understanding the nitty gritty of how the Dow -- as well as other stock market gauges -- are calculated can give you a better understanding of what it actually means when the market takes a dive (as it's been prone to do of late) or soars to new highs.

And knowing a bit more about stock averages and indexes may even help you improve your own investing efforts, or at least better understand how you're faring. But let's start with your question: Just how do you go about computing the Dow?

Back in 1896 when Charles Dow launched the Dow industrial average with 12 stocks -- as opposed to the 30 in the average today -- he arrived at the Dow by simply adding up the closing prices of the dozen stocks and dividing by 12.

But today's methodology, though conceptually the same, differs in one key way. You still start by totaling the prices of the Dow stocks, which now number 30. But because of the many changes to the Dow over the past 114 years -- stock splits, spinoffs, companies moving in and out of the average -- you no longer divide by the number of stocks, or 30.

Instead, you use a divisor that's calibrated to make today's Dow average comparable to past levels despite the shifts in its composition. That divisor is currently 0.132129493. It changes from time to time as stocks are swapped in and out of the index (as well as for a few other reasons). But you can find it on page C4 of the Money & Investing section of the Wall Street Journal, not to mention online.

So if you want to calculate the level of the Dow on your own, you can jot down the prices of the 30 Dow stocks, add them up and then divide the total by 0.132129493 (or, if you find it easier, you can multiply by 7.56833298, which yields the same result).

Or, if you don't want to do all this number crunching by hand, you can go to Dow Jones Indexes, click on Current Component Report, and you'll get a nice little spreadsheet with the closing prices of each Dow Industrials stock.

From there, calculating the Dow is a matter of a few mouse clicks and keystrokes. If you went through this process for the Dow prices ending July 22, the 30 stocks would total 1,363.88. Dividing that figure by 0.132129493 (or multiplying by 7.56833298) would give you 10,322.30, which was the Dow close.

One thing the Dow spreadsheet I mentioned also shows is the percentage of the index that each of the 30 stocks represents. That percentage is based on the stock's share price, which means that stocks with higher share prices tend to have a greater impact on the Dow's ups and downs than stocks with lower share prices.

This can lead to perverse results. Exxon (XOM, Fortune 500) has a total market value of roughly $273 billion, which is about 70% higher than IBM's market capitalization of some $161 billion. But since IBM (IBM, Fortune 500) has a higher share price than Exxon -- $127.47 vs. $59.38 based on yesterday's close -- IBM contributed more to the Dow's climb yesterday than Exxon (16.7 points vs. 9.2 points) even though IBM's share price actually rose less than Exxon's (1.8% vs. 2.1%). In short, because of the Dow's price-weighting methodology, a smaller company drove the Dow's value much more than a far larger firm.

I think it makes more sense for a company's sway in an index to be based on its market value. After all, "the market" is essentially the amount of money invested in stocks. So if you want to track the market as a whole, you really want to know what's happening to investors' total wealth in stocks. And companies' market values, or market capitalization, are a better gauge of overall investor wealth in equities than their stock prices (which with splits and such can be somewhat arbitrarily set).

In fact, most of the other indexes that professional investors follow are weighted by market capitalization, which means, all else equal, a company with a higher market value will have more influence on the index's ups and downs.

I still have a soft spot in my heart for the good old Dow. But if you really want to know what's going on in the stock market, you're better off following a broad index like the Standard & Poor's 500, which tracks the market value (actually, market value adjusted for float) of 500 large companies in 10 economic sectors, or an even broader index like the Wilshire 5000, which measures the performance of pretty much the entire U.S. stock market, from the big stocks to the small fry.

If you want to monitor foreign stocks, MSCI has a slew of international indexes you can check out, including its closely watched EAFE index. And if you want to keep tabs on the bond market, head over to Barclays.

So what's the value of checking out these benchmarks aside from being able to astound friends and family with fascinating tidbits like the fact that General Electric (GE, Fortune 500) is the only company in the original Dow that's still in it today?

Well, monitoring stock and bond indices is a good way to gauge the performance of your investments. That's not to say that you need to track a benchmark exactly. Indeed, your investments aren't likely to move precisely in sync with an index unless your portfolio matches the composition of the index.

But if your returns are radically different, for better or worse, then you've got to ask yourself why. Are you really that terrific (or horrible) an investor -- or are you taking a lot more or less risk than the market overall?

You may also be able to gain additional insight by comparing specific portions of your holdings with more specialized indexes, for instance, seeing how the performance of the small stocks you own stacks up against a small-cap index like the Russell 2000 or your growth- or value-oriented mutual funds compare to a growth or value index.

I also think that keeping tabs on indexes and comparing your portfolio's performance to them can help you appreciate how hard it is to outperform the market. Most pros don't manage to do that over the long term after accounting for costs and fees. It's even more difficult to come out ahead after taxes. Once investors realize this, I think they're probably more likely to consider devoting at least some of their money to index funds, such as those on our Money 70 , which offer diversification, consistency, tax-efficiency and low costs.

But whatever your goal, you've now got the info you need to calculate the Dow Jones Industrial Average on your own. And I hope I've also piqued your interest in indexes enough for you to check out benchmarks beyond the Dow.