Why is the Dow Jones Industrial Average (DJIA) price weighted?


Why Is the Dow Jones Price Weighted?

A price-weighted index uses the price per share for each stock included and divides the sum by a common divisor, usually the total number of stocks in the index. The Dow Jones Industrial Average (DJIA) is an example of a price-weighted index. When it was created in 1896 by Charles Dow, it was meant to reflect the average price of stocks in the marketplace.

Key Takeaways

  • The Dow Jones is a price-weighted index, meaning its value is derived from the price per share for each stock divided by a common divisor.
  • The Dow was created by Charles Dow to reflect a simple way of showing the average price of stocks in the marketplace.
  • The Dow Divisor was created to maintain historical continuity in the value of the index since it accounts for changes, such as stock splits.

Understanding Why the Dow Jones is Price Weighted

Charles Dow likely chose to create a price-weighted index due to its simplicity. At the time, investors were new to the idea of stocks. Previously, bonds were the typical investment, and their price stability and interest payments were easy for investors to grasp. The Dow Jones Industrial Average gave investors a simple way to track the stock market’s performance. Thus, the index that originally contained 12 companies was calculated by adding all the stocks’ prices and then dividing that number by 12.

Today, the Dow Jones consists of 30 stocks, and since the index is price-weighted, the higher-priced stocks have a greater impact of the Dow’s value than the lower-priced stocks. The 30 companies included in the index are picked by The Wall Street Journal. The Dow Jones has historically tracked along with the same trends as those in the broader market and can often be a predictor of upcoming trends.

The Dow Divisor

Although in the past, the Dow’s value was calculated as a simple average by totaling each of the component’s prices and dividing the result by the total number of companies. However, companies over the years have been removed or added while others have issued stock splits and spin-offs. These changes have impacted the prices of the stocks and the makeup of the index. As a result, it would be impossible to perform a historical comparison of the Dow’s current value versus in years past since so many of the components and prices have changed.

The Dow Divisor was created to maintain historical continuity in the value of the index. Over time, the divisor has been adjusted from the total number of companies in the index to a number that helps account for stock splits and reverse splits that affect the price per share. The adjustments have lead to modifications in the Dow Divisor, from 16.67 back in 1928, to approximately 0.147 as of September 2019. In other words, a $1 price move is a Dow component would equal to approximately a 6.8 point move in the Dow index or ($1 /.147).

However, some critics argue that a price-weighted index, even with the divisor, is antiquated and lacks credibility. Nonetheless, the value of the Dow is widely used by market participants and the media as a gauge of the overall market’s performance.

Original Source