The Dow Jones Industrial Average is one of the most iconic indicators of the U.S.’s economic health. Thirty stocks are selected from a variety of industries to track the performance of the overall economy. Yet, for all its import, the Dow is calculated in broken way.
How does it work? The prices of the thirty stocks that comprise the Dow are summed and this sum is divided by the “DJIA divisor,” which is currently about 0.13.
This divisor exists to prevent discontinuities in the Dow when the component stocks change (or split). The composition changes when the folks at Dow Jones decide that a different set of stocks better represents the economy. For example, Microsoft and Intel joined the Dow in 1999, replacing Goodyear and Union Carbide, among others. When such changes occur, the divisor is adjusted so that the value of the Dow immediately before the change is the same as immediately after the change.
The result is that the more expensive stocks on a per-share basis end up having a disproportionate impact on the Dow. Microsoft’s stock (circa $25 per share) would need to increase 2.5% to have the same impact on the Dow as Boeing’s stock (circa $65 per share) going up 1%. If Google (circa $535 per share) were ever to join the Dow, a 5% decrease in its share price would have the same effect on the Dow as Microsoft going bankrupt.
Moreover, a company’s market cap doesn’t figure into any of this either. Microsoft’s market cap is over 4 times Boeing’s, so that 2.5% change in its stock price mentioned above corresponds to 10 times the change in market cap of Boeing’s 1% change. That means that events which differ an order of magnitude in their effect on stock value can have exactly the same impact on the Dow.
I’ve always been curious about how this plays out in practice, and the below visualization is an attempt to get a better understanding of how the various stocks in the average affect the whole. The 30 component stocks in the Dow are laid out loosely based on the location of their headquarters. The size of each circle represents the company’s market cap. The most interesting aspect, though, is the color of each circle: it corresponds to the ratio between the stock’s current weight in the Dow and the stock’s weight if the Dow were based purely on market cap. The higher (redder) the ratio, the more a change in a stock’s market cap affects the Dow. Mouse over any of the circles for more information about the stock.
[See a larger version]
For those who are curious, the visualization was made with Protovis, an amazing library developed by the Stanford Visualization Group.
