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What Is the Dow Jones Industrial Average? DJIA

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  • What Is the Dow Jones Industrial Average? DJIA

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    It occurred to me today that one of the most frequent questions I get is "What is the DJIA?" So I thought in order to be proactive, I would do my best to explain what it is.

    Both the DJIA and S&P 500 are market indexes. Essentially they try to track the progress of the broader market, although the take different approaches to doing so. If you have ever heard someone mention that "The market is way up today." they were talking about either the DJIA or S&P500 or both. Dow Jones is a subsidiary of Standard and Poor's which is a subsidiary of the finance and education giant McGraw-Hill. A little background on McGraw-hill, they are a split company with half of the business (McGraw Hill Financial) specializing in financial ratings and analysis, with J.D. Power and Associates lumped in. The other half (McGraw-Hill Education) specializes in educational publishing. Many of you may remember having a McGraw-Hill textbook in grade school.

    The Dow Jones Industrial Average, or DJIA, was first reported in 1896 by Charles Dow & Co., and the index is named for Charles Dow and a statistician named Edward Jones (No relation to the financial firm Edward Jones). The average was initially of 12 industrial stocks and meant to be a barometer of sorts for the industrial industry in the United States. Over the years the DJIA has grown to 30 companies, and while it retains the "Industrial" in its moniker, in practice, the DJIA has shed its industrial focus and evolved into a broader market indicator. The DJIA now encompasses 30 blue-chip companies that represent the broad market, the DJIA does not include any utility or transportation companies, as Dow Jones has separate indices for both. While there is no set formula for what companies are selected, but of the original 12, only General Electric (GE) remains. The selection criteria are explained fairly vaguely by Dow Jones:

    "While the stock selection is not governed by quantitative rules, a stock typically is added to The Dow® only if the company has an excellent reputation, demonstrates sustained growth and is of interest to a large number of investors. Maintaining adequate sector representation within the indices is also a consideration in the selection process."

    The DJIA is not the average price of the component companies, but rather a price-weighted scaled average.

    Oh, that sounds terribly confusing... Well it is and it isn't here's why:

    The average is calculated the same way, but instead of using the number of component companies (30) as the divisor, you use the Dow Divisor. The Dow Divisor is an incredibly complex number that is constantly being updated (I'll go over that later) but you don't have to calculate the Dow Divisor, Dow Jones does that for you.

    An example would look a little something like this; to make things very simple, imagine 10 companies trading at $10 per share. To find the average you would add the total of the companies stock, and divide by the number of companies, and because this is a very simple example you quickly realize the average is $10. Compare that with using the Dow Divisor:

    10 stocks x $10 per share = $100

    $100 / 0.14985889030177 = $667.29

    $667.29? How can that be the average price of the 30 component companies when none of the component companies trade near that price. Well, you remember that price weighted scaled average part? This is where it comes into play. Because the DJIA is over 100 years old, a lot has changed over its lifetime. Companies were added and dropped, most recently Apple (AAPL) this month, stock splits and dividends occurred, etc. and all of this has had an impact on the average. For example, while GE trades for roughly $25 and change at the time of my writing this, they also have 10.07B shares outstanding. When GE was initially incorporated there were 1,000 shares sold at $100 per share, and the first trade listed by the NYSE was made 6 months later a transaction of 50 shares at $108 per share. ( Investor Relations FAQs). So you can see why that number needed to be scaled for historical continuity, a share price of $25 x 10.07 billion shares is very different than a share price of $100 x 1000 shares and to accurately reflect the value of the company in "1896 dollars".

    To look at it another way, let's use our previous example. If you have 10 companies trading at $10 per share, your average is $10. Now if one of those companies has a 2:1 stock split the share price will be halved to $5, this makes the average $9.50 despite the fact that the company who's stock split is no less valuable. Add every minute stock split, stock dividend, company change, etc. together and you end up with the Dow Divisor. The Dow Divisor is now so far below 1.0 that it acts as a multiplier, which is why the DJIA average can be in the 18,000 range, while the component companies stock trade for a total sum of less than half that number.

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