How much do you really know about the Dow?
“The Dow today topped the 29,000 mark!” We hear headlines like that again and again. But what do they mean?
Investors often refer to “the Dow” and other indexes, when talking about their investments. They’re like someone’s blood pressure readings: the numbers are significant, but few know what’s really behind them. They are a form of shorthand used as a barometer for the status of the entire stock market.
A recent change in the Dow went unnoticed by many, yet it had some meaningful implications.
At the end of August, a series of changes took effect on the Dow Jones Industrial Average or the Dow. Among the most important is the first change to the index’s divisor since April 2019.
To grasp the importance of that change, let’s first look at the so-called “divisor” and then look at the history of the Dow to put it into context.
What is the Dow divisor?
Take a look at regular math, and you’ll see you’ve dealt with divisors since the second or third grade. It’s the number at the bottom of a fraction. You’re going to “divide” the upper number by the lower number, so the lower number is called the “divisor.” There’s no mystery there.
The history of the Dow and its divisor
In 1884, Charles Dow created his “Average;” the index brought together 12 of the largest publicly-traded companies in the U.S. With time, the number grew to 30 companies.
The purpose was to provide investors with an average per-share price for the stocks during a typical trading session of the market. The stock prices of those companies were added up, then divided by 30. You had a simple average.
It was not a weighted mean. Nor did it represent the market capitalization of any given individual company in the index. (The S&P 500 and the NASDAQ, for example, are weighted by the market capitalization of their components.)
However, time led to a more sophisticated formula to consider stock splits, changing or paying dividends, or changing the companies that made up the average. By adjusting the Dow divisor, the index would be modified, thus allowing investors to compare past and present Dow averages on equal footing.
More critical, updating the Dow divisor helps keep the Dow closest to fair value and is said to help investors and traders make the best investment decisions.
What triggered the change now?
As you can imagine, if a major Dow component company goes through a stock split, that can swing that company’s influence within the index.
That’s exactly what happened when Apple’s stock underwent a 4-for-1 split after the close of trading on Friday, Aug. 28. Apple went from representing 12 percent of the entire Dow to 3 percent.
The announced reason for the split was to make its shares more accessible to investors. (It had been trading at around $500.) Apple’s stock has split five times since it went public in late 1980, and, had it never split, a share would be trading at around $28,000 today.
Another reason was to bring its stock price more in line with its peers in the Dow. Where Apple had been the biggest component in the Dow before the split, it would fall to a middle position after the split. (The top spot would go to UnitedHealth Group.)
What other changes just took place?
Apple’s action also triggered the Dow to change its list of component companies. The changes would represent the 57th time it has done so since the index was formed.
The last time the Dow swapped out more than one company was in 2013. At that time, Bank of America, Hewlett-Packard and Alcoa were dropped. Goldman Sachs, Visa and Nike were added.
This time, the Dow dropped three stocks with prices on the lower end: Pfizer, ExxonMobil and Raytheon Technologies. Salesforce, Amgen and Honeywell International were added.
When the index’s most heavily-weighted stock (Apple) dropped to 17th or 18th place, and Amgen was added to the mix, the new top three companies became UnitedHealth Group, Home Depot and Amgen.
Apple’s influence within the index decreased when it lowered its share price by splitting 4-for-1. In turn, Dow’s committee said it made changes to the list’s composition to offset that reduction and to reflect today’s American economy better.
So, why did the divisor change?
We know the value of the Dow is calculated by adding up the prices of its components. Apple’s lower stock price meant the divisor had to change to provide continuity for the overall basket of stocks. According to MarketWatch, the divisor rose from 0.147 to 0.152.
And how does that affect investors? With the new divisor, a $1 price move in the stock of any Dow component company translates into a swing of 6.579 points on the Dow, instead of 6.8 points as before.
What does the Dow change mean to you as an investor?
The changes to the Dow are not meant as recommendations for you to buy or sell any company stocks in particular. Instead, they are meant to create a better barometer of what is happening in the economy.
But the real value of understanding how the Dow works is to help you decide what role its fluctuations should play as you make decisions about your stock portfolio.
Some people question how representative 30 stocks can be of an entire economy. Remember that the index reflects the stock’s market price, not its valuation. And stock prices are subject to so many influences: news cycles, management changes, narratives, popularity, disasters, etc.
The uncertainty in today’s economy that comes from aspects as diverse as the virus, possible vaccines and presidential elections has reinforced the importance of discipline and strategy as you balance and rebalance your stock portfolio.
Knowing the best tools to use in your decision-making – including the Dow index – can’t be over-emphasized.