Dow Jones Industrial Average – How Much Should Each Stock Weigh?

Tuesday, November 24, 2009

776906_balanza_scales-editThe Dow Jones Industrial Average (DJIA), like all indexes, needs a method for weighting each of its component stocks. Yesterday, I said I prefer to apply an equal weight. Today, I will explain that rationale further because, in the days ahead, I will be doing some analysis using that approach…

The DJIA has an odd-looking weighting scheme: by stock price. It is unrelated to any company fundamental measure, so articles periodically pop up denigrating the index – particularly when it crosses a round number with fanfare, like its recent rise above 10,000.

In the 1800s when Charles Dow created the Dow Jones averages to measure general market moves, his use of price weighting made sense. It was actually a form of equal weighting. At the time, stocks were quoted as percents of par value, and par value (typically $100 per share) was viewed as similar to a bond’s face value. So, when Dow averaged the prices, he was picking up the average stock’s relationship to 100. This type of quotation did not change until 1915.

The other important ingredient in Dow’s averages was the inclusion of large, leading companies. Therefore, there was no reason to weight by company size. The DJIA’s 30 stocks are chosen the same way today, and they are well diversified among major sectors and industries. To reflect size and importance, Dow Jones selects more than one company in a sector.

Many indexes use market capitalization weighting. The benefit is that this methodology allows combining different sized companies into a single index, such as the Standard & Poor’s 500 Stock Index (S&P 500).

Below are the sector allocations in the DJIA, using equal weighting, compared to the S&P 500’s market capitalization weighting. Dow Jones has done a nice job capturing the US stock market’s composition with the 30 companies. (Note: “Conglomerates” look over-weighted, but this catch-all category covers companies with operations spread among the other sectors. For the DJIA, the three conglomerates are General Electric, 3M and United Technologies.)

DJIA equal wt table

So, an equal weighted DJIA gives us the information we need to analyze and understand the state of the stock market.

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November 2009