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Friday, April 17, 2009

Dow Jones Industrial Average Weighting Understanding the Dow Divisor

Many times I've heard people say why is the Dow Jones Industrial Average (DJIA) so much higher than the S&P 500, when the DJIA consists of just 30 stocks and the S&P 500 consists of 500? The answer to this is quite easy and just takes a little calculating. The Dow Jones Index is weighted unlike the S&P 500. The S&P 500 is weighted by market cap; the larger the stock the more affect it has on the daily move of the S&P index. However the DJIA has a weighting so that a 1 point move in any of the 30 stocks will move the index by an equal number of points. To understand this you need a quick history lesson. In 1896 to be exact the index consisted of just 12 stocks, and to get the average back then all you'd need to do is divide the total price of all 12 stocks by 12... Easy isn't it! But if that were the case today it would mean that the basket of 30 stocks in the DJIA would sum to around 243,750 as of toady's close anyway. As you may know this is not how you get the average. Over time stocks were added and taken out of the index, as well as stock splits and spinoffs, etc... In order to keep the DJIA consistent the "divisor" must also change. The current divisor is published on page C4 of the Wall Street Journal daily.

The current divisor as of April 17, 2009 is .125552709. To get an idea of what this means we'll divide 1 point by the divisor and we get 7.9647. This means that a 1 point change in any of the 30 stocks will move the index up/down by 7.9647 points. For example we'll say that 28 of the 30 Dow components finish the day unchanged but BAC and C both moved up 1 point, we could calculate the index average change by dividing 2 by the divisor... The index would move higher by 15.93 points on this day. Since all of the 30 Dow stocks are weighted so that a one point change affects the index equally, one would have to take the sum of all 30 stock prices in the Dow index and divide by the Dow divisor. The picture below shows a spreadsheet of the Dow 30 and how it would affect the Dow Jones Index if any given security went to 0. Also you can see that the total sum of all 30 Dow stock prices is equal to 1020.17 which when divided by the current divisor will give you the close price on April 16, 2009; 8125.43.
(Click on the image below to get a larger more clear view)



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