Oops! The Wall Street Journal Forgets How the Dow Jones Industrial Average Is Calculated

Tuesday, July 20, 2010

The weekend edition of The Wall Street Journal carried the headline: “BofA Drives Dow Drop” (July 17-18, by Donna Kardos Yesalavich, page B-11).

The problem is that Bank of America, in spite of its 9.2% Friday decline, is too small to have much effect on the Dow Jones Industrial Average (DJIA). Too small? Yes, and here’s why.

DJIA – “Average,” not “index”

When Charles Dow created his averages in the late 1800s, the calculation was easy: Add up the prices and divide by the number of companies. The reason that made sense was that stocks sold in relationship to par value that was typically $100 per share. For the couple of $50 par value stocks, Dow actually multiplied by two before averaging.

Over time, par value lost its importance and stock prices drifted far apart based on investors’ valuation of each company’s results and the number of shares issued. But the averaging process continued, making the Dow Jones averages unique among today’s broad list of stock indexes.

Note: Because of company replacements and actions such as stock splits, the simple division by the number of stocks doesn’t work. Instead, Dow Jones created an adjustment factor, called the “divisor” (currently 0.132129493). To calculate the DJIA, add up the thirty prices, then divide by the divisor.

DJIA – “Price,” not “market value”

Most stock indexes weight each company by its market capitalization (“market cap”) – i.e., the number of shares outstanding times the price per share. Thus, larger companies have a larger effect on an index. For example, Exxon-Mobil (XOM), with its $270 billion market cap, has a 2.7% weight in the Standard & Poor’s 500 Stock Index (S&P 500) even though it is only one of the 500 (0.2%) companies.

In the DJIA, the weight is based only on price. Thus, higher priced shares have a larger effect. For example, IBM (IBM), with its $128 price has a 9.7% weight, over twice that of Exxon’s 4.3% based on its $58 price. (See listing at end of write-up.)

Now look at Bank of America (BAC)

Bank of America is not small. It’s $140 billion market cap ranks only below JPMorgan Chase’s $155 billion among US banks. But, in terms of price, it’s puny: only $14. So, while carrying a high weight in the S&P 500, it has only a 1% weight in the DJIA.

Therefore, rather than “driving” the DJIA lower Friday, Bank of America simply nudged it. If Bank of America had not fallen, the DJIA’s (2.5)% decline would still have been (2.4)%.

So… Stay vigilant in what you see and hear about investments. If The Wall Street Journal can get the Dow Jones Industrial Average’s workings wrong, any source can produce a bad fact, analysis or insight.

Here is the current DJIA listing, showing the weights of each company based on last Friday’s closing price.

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