What Happened Last Week Will Change the Way You View the Stock Market for Years to Come

Last Monday morning, the most widely followed and recognized U.S. index looked different from when it closed the Friday before. The Dow Jones Industrial Average (DJINDICES: ^DJI  ) had swapped out three of its former components for a trio of new ones. That may not seem like breaking news, or anything that investors will ponder for years to come, but let me explain why it may be.

The Dow's weighting methodology
The Dow is a price-weighted index. That means each of its 30 stocks has a greater or lesser influence on the index depending on its stock price. Other indexes, such as the S&P 500, also use a weighting system, but they base their weighting on market capitalization, not share price.

What this means in practice is that the weight of each stock within the index changes with every move higher or lower during the trading day. For example, back on June 19, IBM (NYSE: IBM  ) traded for $203.99 per share and accounted for 10.24% of the index. The following day, IBM traded at $199.54 and accounted for just 10% of the Dow's value. At the time, IBM was the most heavily weighted Dow component, and it had been for quite a while.

As my colleague Anders Bylund explained on those two days, when IBM would gain or lose 1%, it was adding or subtracting 16 points from the Dow. Meanwhile, Coca-Cola's 0.5% move on June 19 added just 1.5 points to the Dow, since Coke represented only 2.08% of the index that day. Given the stark contrast between the influence of those two stocks, it's easy to see why some investors don't agree with the way the Dow works.

The new Dow and the future
With the removal of Alcoa, Bank of America, and Hewlett-Packard, the Dow cut its three most lightly weighted components. Based on their Sept. 20 closing prices -- Alcoa at $8.29, Bank of America at $14.44, and Hewlett-Packard at $21.22 -- they represented around a combined 2% of the Dow's value.

Their replacements were Visa (NYSE: V  ) , Goldman Sachs (NYSE: GS  ) , and Nike (NYSE: NKE  ) . As of Friday's closing price, Visa is the new top dog on the index with an 8.11% weighting, while Goldman comes in third at 6.8%, and Nike places 18th at 2.95%. That's a combined 17.89% of the index -- quite a contrast from the 2% they replaced.

The changes were necessary. IBM's outsized weight made it control too much of the Dow's moves. The addition of two new higher-priced stocks, combined with the removal of the three stocks at the bottom, rebalanced the Dow and helped tone down the influence of the heaviest components.

I agree with most of the Dow's critics that the price-weighting method has some flaws, and I understand that adding a few higher-priced stocks doesn't really change the underlying problem. But I do think this move will make the Dow a better gauge of the overall economy and a more accurate representation of the stock market -- which, after all, is the real purpose of an index.

More Foolishness
Warren Buffett has made billions through his investing and he wants you to be able to invest like him. Through the years, Buffett has offered up investing tips to shareholders of Berkshire Hathaway. Now you can tap into the best of Warren Buffett's wisdom in a new special report from The Motley Fool. Click here now for a free copy of this invaluable report.


Read/Post Comments (1) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 30, 2013, at 12:15 AM, dastaub22 wrote:

    The Dow's math represents the time period when the index was designed. It had to be calculated by hand, no IBM 360 was available.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2659804, ~/Articles/ArticleHandler.aspx, 9/23/2014 4:28:11 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement