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Investing Lingo: Dow Jones Industrial Average (DJIA)

by Juno Moneta
April 17th, 2008, 7:44 pm

We all know what the Dow Jones Industrial Average is, right? Of course! It’s that number that goes up and down and lets me know if the stock market is moving in a healthy direction. If the TV says “the Dow” is up 200 points, I’m happy, because I invest in the stock market. If the Dow Jones goes down 200 points, I’m a little less cheerful, but it doesn’t really matter, because I’m invested for the long run.

Ok, so maybe that’s not specific enough. Who is this Dow Jones guy anyway, and what does this number really represent?

Of course I went straight to Wikipedia, which provides a kind of convoluted definition, and Investopedia, which gave me a much more straightforward explanation. Invented by Charles Dow and possibly Edwin Jones and Charles Bergstresser (clearly, an index named the Dow Jones Bergstresser Industrial Average would have never worked), the Dow Jones Industrial Average is one of several stock indices used to represent the performance of the overall stock market. It is a “rigged average” - I’ll explain this term in a minute-of the stock prices of a group of 30 companies. Yes, just 30 companies-not every publicly traded company. Who picks the 30 companies? The editors of the Wall Street Journal, and yes, they do change sometimes.

By rigged average, I mean it’s not a regular average, which would be what you got if you added the prices of the companies up and divided that number by 30. If you did that, each company in the index would be valued equally when you calculated the average. But over the years, company stock has split and there have been dividend payments and all kinds of factors that affect the stock’s value. So the Dow Jones Company people change the divisor (the number that you divide the combined price of the 30 stocks by) to better reflect the true value of the companies involved. This is confusing, so here’s an example:

Let’s say you have 2 companies: The Red Shoe Company and the Classic Jeans Company. These two companies make up our Super Stock Index.

Situation 1

The Classic Jeans stock price is $20 and the Red Shoe stock price is $40. So the regular average price of both of these would be $30, or $20 + $40, divided by 2. Easy enough. The Super Stock Index is at $30 today.

Situation 2

Okay, now let’s say the Red Shoe stock price “splits.” So people who owned one share of Red Shoe now own 2 shares–Red Shoe A and Red Shoe B–and each of those shares is now worth $20. Together, the owner of Red Shoe has double the shares, but their combined value is the same as the original value of just one share. Stay with me here, there is a point to this.

So now if you wanted to calculate the new average value of the Super Stock Index, would you say the average is $20 + $20 (the new Red Shoe price, plus the Classic Jeans Price), divided by 2? That would give you an average of $20, which is less than our average of $30 that we had in Situation 1. This can’t be right, because the value of Red Shoe hasn’t actually decreased. The person who owned $40 worth of Red Shoe in Situation A still owns $40 worth of stock, not $20. They just have twice as many shares now.

This is where the “rigged” average concept kicks in. The Dow Jones Company people look at the stock splits and other activity that could skew the integrity of the average, and they change the divisor (denominator) used to divide the sum of the thirty stocks so that it reflects the true value of the companies. Instead of dividing $60 by 2, they would decide that you now divide $40 (the new Red Shoe price + Classic Jeans) by 1.333, which will give you a Super Stock Index average of $30. The divisor changed from 2 to 1.333 in this example.

So why do we care about the DJIA? Because it indicates the performance of the 30 companies that the Wall Street Journal editors think are “leaders of the economy” and so therefore reflects something about the health of the overall market. It’s probably better to think about it in conjunction with other indices like the Standard and Poor’s (S&P) 500, or the Nasdaq Composite average. All of these indices provide a snapshot that reflects the health of the overall stock market without having to take every single American publicly traded company into account.

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Posted in Good to Know, Lingo |