The Daily Dow
Wednesday, June 25, 1997
by Robert Sheard
LEXINGTON, KY. (June 25, 1997) -- As much a fan of the Dow Approach as I am, I nevertheless bristle at a couple of the aspects of the way the Dow Jones Industrial Average is maintained. Aside from the prejudice against stocks not listed on the New York Stock Exchange, and thus the exclusion of companies like MICROSOFT <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %> and INTEL <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: INTC)") else Response.Write("(Nasdaq: INTC)") end if %>, the Dow also holds on to an archaic computational method that dates back to pre-computer days -- price weighting.
Since the method of calculation simply requires the addition of the 30 stocks prices (divided by an adjustable factor to account for special events like splits and revisions to the list), the stocks with the highest prices have the most influence over the movement of the index. For example, if J.P. MORGAN <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: JPM)") else Response.Write("(NYSE: JPM)") end if %> trades at $100 a share and WAL-MART <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WMT)") else Response.Write("(NYSE: WMT)") end if %> trades at $33 a share, Wal-Mart's price would have to move three times more than J.P. Morgan's (in percentage terms) to have the same effect on the Dow Jones Industrial Average.
Suppose J.P. Morgan stock rises $2 a share. That's a percentage gain for J.P. Morgan shareholders of only 2%. But a $2 rise in Wal-Mart (which would have exactly the same effect on the overall movement of the Dow), represents a gain of more than 6% for Wal-Mart shareholders. The effect of this method of calculation is to skew the results toward how the highest-priced stocks are performing and all but eliminate the effect of the lowest-priced stocks. The reason for this method is that Charles Dow needed a quick manual approach to track the stocks since computers were a distant prospect when the Dow Jones Industrial Average was launched in the last 19th Century. Today, however, no such impediment exists and a much more representative approach would be to measure the percentage gains in each stock, not the simple price movements. That way a 5% gain in the lowest-priced stock in the index has the identical effect of a 5% gain in the highest-priced stock. But history gets in the way and once an index gets as long in the tooth as the Dow, it's very difficult to change the way things have always been done.
Tied to the problem of using a price-weighted index is the fact that when a stock in the index does split, this simple and financially meaningless event tends to lock in a gain for the index itself. Let me explain.
Companies typically split their stocks after extensive and healthy gains in the price. Many of the mature companies included in the Dow often allow their stocks to rise to a certain price and then split the stock to bring the price back into a more typical range, one their investors are comfortable with. The act of splitting a stock really means nothing in terms of an investor's share of the business, but it's a psychological game companies play. Most investors are more willing to buy 200 shares of a stock at $50 a share than 100 shares of the same stock at $100 a share. So a company splitting its stock is typically the sign that the price has risen of late and these gains in the stock's price are reflected in the Dow Index.
When a company splits the stock, though, the flexible divisor used in calculating the Dow is adjusted so that the index is maintained exactly at the same level. If the Dow is at 7,500, for example, when J.P. Morgan splits 2-for-1, the Dow will still be at 7,500 immediately after the split, even though J.P. Morgan's price has been changed from, say, $120 to $60. Because of the price-weighted calculation method, though, J.P. Morgan's influence over the index itself has now been cut in half. At $120 a share, J.P. Morgan only had to gain 2.5% to rise $3 a share. Now at $60 a share, it would have to gain 5% to move $3 a share. In effect, then, the gain J.P. Morgan posted before it split is protected inside the value of the index because the act of splitting its stock cuts its influence on the overall index.
If the stock were to sink after its recent gains (the reason for the split), the effect of those losses is reduced by half since the raw share price is now $60 lower than before the split. Again, an index that measured percentage gains or losses in each stock rather than gains or losses in the dollar amounts per share would be a much more representative index of how these thirty stocks are actually performing.
So what can we do as individuals to get a more representative view of the
index's real performance? One way is simply to track your own index of the
same thirty stocks, but weighted equally so percentage gains determine the
index's movement, not raw price gains. But that requires some effort many
investors may see as unwarranted. Another easy way to gauge your portfolio's
performance is to set it side-by-side with a real index fund. Since an index
fund is the baseline alternative for most investors (and still beats more
than 80% of all stock funds), using one's actual return instead of the
hypothetical indices gives you a real-world comparison, including costs and
dividends. You can find any number of index funds (for either the S&P
500 or even now for the Dow Jones Industrial Average) in one of the mutual
fund services like
Lipper. Lipper's
site even updates performance numbers nightly for the current year, so you
can bookmark the page for the fund you use as a comparison and check it almost
as easily as any other stock quote.
(c) Copyright 1997, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool. ________________________________
Stock Change Last -------------------- T + 1/16 37.00 GM - 3/4 56.00 CHV - 7/16 73.81 MMM + 5/16 101.25
Day Month Year
FOOL-4 -0.26% 3.16% 3.60%
DJIA -0.88% 4.90% 19.26%
S&P 500 -0.82% 4.80% 20.01%
NASDAQ -0.43% 3.28% 12.02%
Rec'd # Security In At Now Change
1/2/97 120 3M 83.00 101.25 21.99%
1/2/97 153 Chevron 65.00 73.81 13.56%
1/2/97 179 Gen. Motor 55.75 56.00 0.45%
1/2/97 479 AT&T 41.75 37.00 -11.38%
Rec'd # Security In At Value Change
1/2/97 120 3M 9960.00 12150.00 $2190.00
1/2/97 153 Chevron 9945.00 11293.31 $1348.31
1/2/97 179 Gen. Motor 9979.25 10024.00 $44.75
1/2/97 479 AT&T 19998.25 17723.00 -$2275.25
CASH $609.53
TOTAL $51799.84