"The Dow." It's a presumed proxy of the entire stock market. But many of us don't fully appreciate what it really is -- and what its limitations are.
For starters, while the S&P 500 includes 500 big American companies, and "total stock market" indexes such as the Dow Jones Wilshire 5000 include several thousand, the Dow Jones Industrial Average features just 30.
That's just one of the Dow's shortcomings -- and these days, they're more pronounced than ever. Take the Dow's price-weighting, which means that the stocks in the index with higher prices carry greater weight in caluclating the overall average.
So with IBM
Meet the divisor
Let me back up a bit to give you a fuller picture. The Dow is essentially the average price of the 30 component stocks. That might seem kind of impossible, since most stock prices we pay attention to tend to be between, say, $5 and $200, and the index has recently been fluctuating around 8,000.
But if the companies in the index had never split their shares, issued dividends, or undergone major changes such as spinoffs or mergers during the time they were listed in the index, their average price would be around $8,000. Take component Coca-Cola
So how do we get from the current modest stock prices to the Dow's value around 8,000? Well, there's a little trick involved -- called the "divisor." It was recently 0.1255527090. The original divisor -- back in 1896, when the Dow was created -- was just the number of stocks in the average (12). However, to account for stock splits, mergers, and such, the divisor has to be adjusted frequently. (A few years ago, it was 0.14452124.)
Take a component's stock price, divide it by the divisor, and you'll see how many Dow points it represents. Coca-Cola, for example, recently traded near $43, which works out to 342 points in the Dow.
A recent study by Bianco Research noted that financial companies' recent low prices mean those stocks have ceased to have much effect on the Dow. With many financials trading under $10 per share, the Dow would only lose a few hundred points, even if all of them fell to zero.
In addition, there's a good chance that some Dow stocks with Lilliputian prices will get booted out of the index in the near future, because the Dow typically frowns on stocks with prices below $10. When that happens, and the companies are replaced, we can expect the index's dynamic to change -- again.
Well, as you take the pulse of the market in this volatile but exciting time, don't pay too much attention to the Dow. When you see how it's changing from day to day, it's really only telling you how a few stocks have performed.
Also, know that there are other ways to build indexes, other than weighting components by stock price, which usually doesn't tell you too much by itself. The S&P 500 index, for example, is a market-cap-weighted index, giving the companies with the greatest market values the most influence.
Bargains? In the Dow? You'd be surprised:
Longtime Fool contributor Selena Maranjian owns shares of Coca-Cola, Microsoft, General Electric, and McDonald's. Coca-Cola and Microsoft are Motley Fool Inside Value picks. Try our investing newsletters free for 30 days. The Motley Fool is Fools writing for Fools.