The daily performance of the Dow Jones Industrial Average is a staple portion of the evening news report. Although the Dow Jones is best-known measure of the performance of stock market, it is only one of several indicators. Other more broadly based indexes are computed and published daily. In addition, several indexes of bond market performance are widely available.
The ever-increasing role of international trade and investments has made indexes of foreign financial markets part of the general news as well. Thus foreign stock exchange indexes such as Nikkei Average of Tokyo and the Financial Times index of London are fast becoming household names.
Dow Jones Average
The Dow Jones Industrial Average(DJIA) of 30 large, "blue-chip" corporations has been computed since 1896. Its long history probably accounts for its preeminence in public mind. (The average covered only 20 stocks until 1928.)
Originally, the DJIA was calculated as the simple average of stocks included in the index. Thus, if there were 30 stocks in the index, one would add up the prices of 30 stocks and divide by 30. The percentage change in the DJIA would then be the percentage change in the average price of the 30 shares.
This procedure means that the percentage change in the DJIA measures the return (excluding dividends) on a portfolio that invests one share in each of the 30 stocks in the index. The value of such a portfolio (holding one share of each stock in the index) is the sum of the 30 prices. Because the percentage change in the average of 30 prices is the same as the percentage change in the sum of the 30 prices, the index and the portfolio have the same percentage change each day.
Because the Dow measures the return (excluding dividends) on a portfolio that holds one share of each stock, it is called a price-weighted average. The amount of money invested in each company represented in the portfolio is proportional to that company's share price.
Consider the data for a hypothetical two-stock version of the Dow Jones Average. Let's compare the changes in the value of the portfolio holding one share of each firm and price-weighted index. Stock ABC starts at $25 a share and increases to $30. Stock XYZ starts at $100, but falls to $90.
Portfolio: Initial value = $25+$100 = $125
Final value = $30+$90 = $120
Percentage change in portfolio value = -5/125 = -0.04 = -4%
Index: Initial index value = (25+100)/2 = 62.5
Final index value = (30+90)/2 = 60
Percentage change in index = -2.5/62.5 = -0.04 = -4%
Notice that price-weighted averages give higher-priced shares more weight in determining performance of the index. For example, although ABC increased by 20%, while XYZ fell by only 10%, the index dropped in value. This is because the 20% increase in ABC represented a smaller price gain ($5 per share) than the 10% decrease in XYZ ($10 per share). The "Dow portfolio" has four times as much invested in XYZ as in ABC because XYZ's price is four times that of ABC. Therefore, XYZ dominates the average.
You might wonder why the DJIA is now (in mid-2006) at a level of about 11,000 if it is supposed to be the average price of the 30 stocks in the index. The DJIA no longer equals the average price of the 30 stocks because the averaging procedure is adjusted whenever a stock splits or pays a stock dividend of more than 10%, or when one company in the group of 30 industrial firms is replaced by another. When these events occurs, the divisor used to compute the "average price" is adjusted so as to leave the index unaffected by the event.
Suppose XYZ were to split two for one so that its share price fell to $50. We would not want the average to fall, as that would incorrectly indicate a fall in the general level of market prices. Following a split, the divisor must be reduced to a value that leaves the average unaffected. The initial share price of XYZ, which was $100 falls to $50 if the stock splits at the beginning of the period.
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