Since 1896, the Dow Jones Industrial Average gauged the performance of the stock market. From 12 stocks that originally tracked the performance of American industrial sector, it has grown to 30 stocks that represents one of the most widely mentioned index of the US stock market.
How the Dow Jones Industrial Average is Calculated
In order to prevent events like stock splits or spinoffs to affect the numerical value of the index, a divisor (sometimes known as the DJIA divisor) was created. Originally, the divisor was 12, which effectively made the index a simple average of all the stock prices of the components. As more stock splits and structural changes occurred through the years, the divisor kept being readjusted downwards (as of the end of 2008, the divisor stands at 0.125552709).
If you were to calculate the average today, all you have to do is add up the stock prices of all the components in the Dow (currently 30 of them) and then divide that by the DJIA divisor.
What the Dow Jones Index Means for Us
Knowing a few details about the average really help us become a better investor of the Dow. Here’s a couple you should know about:
- The Stock Price is Just Added Together – This translates to a higher stock priced company having more affect on the Dow Jones Industrial Average than other smaller priced ones. For example, if there was a 10% move in a $100 stock, it will bump the average much higher than a 10% move in a $10 stock. As of writing, the highest priced stock in the Dow is IBM.
- Sectors Dominating the Average – Financials used to be a huge part of the Dow Jones index, but after the troubles of Bank of America, Citigroup and JPMorgan as well as American Express, the sector has a much smaller effect on the average. As of the beginning of 2009, the average is highly weighted in Technology.
- Not All 30 Components Open at the Same Time Every Morning – If you see a huge jump (up or down) of the average early in the session, you are seeing the effect of this. Therefore, looking at the price history may not be a good way to do a technical analysis.
Knowing these will greatly enhance our ability to predict the future of the average. For example, we know that in order for the average to stay the same on a day that IBM went up 10%, American Express, Bank of America, Citigroup, JPMorgan, and General Electric all have to be down roughly 15% (approximation based on stock prices on Feb 1, 2009). Therefore, we can conclude that if IBM is doing well, the average will likely do better than even a few financial firms rallying on the same day.
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Very good post. I was not aware that the divisor was being used in this manner, and it is so easy to calculate the index.
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