QOD
During my long drives to work I have time to think about things because I don’t have my Sirius satellite and have to listen to regular radio and all the f’ing commercials. NPR however is the bomb I must say, even when the play David Frum editorials and don’t mention he was Bush’s speechwriter. That and when they have Bank of America Economists talking about President Obama’s stimulus package being the largest ever “PEACE TIME” spending this country has ever seen. I guess that guy doesn’t realize we are fighting two wars. That’s ok, neither does 80% of the country.
Anywhooo, my question is this:
Historically people have always said the stock market over time always goes up and blah, blah, blah. Then they talk about how the DOW this and the DOW that. Historically they have this and that.
Actual question:
Don’t they move in and out companies in the DOW? Doesn’t that skew the historical numbers? Isn’t it sorta bullshit to say that the DOW has always performed XY and Z over year x to year y? GM is getting moved out, Sears got pushed out a decade ago and along the way others have been added in right?
I think you could argue both ways, DV. I might argue that it’s good to change it up because the business community is always changing. Business go in and out of business, get merged, get broken up and so the Dow should reflect business at its current state.
However, I think you make a good argument that the over-reliance on the movement of the Dow can obscure other things that are happening. I think only looking at the performance of stock indexes is a pretty lazy way to look at the economy.
Somewhere there are arcane papers by finance professors analyzing the effect of moving companies in and out of the Dow. But I finished B school five years ago, and I’m not sure I want to try and dig some up. It might be interesting to compare the long range performance of the Dow and the S&P 500.
There is an effect for companies being added or dropped by the Dow. Being added provides a slight boost to a company’s share price because investment funds that track the Dow have to buy shares. Likewise, when a company is dropped by the Dow, its share price drops because of funds selling shares.
If we did not replace companies on the DOW (or any targeted index for that matter) then there would be nothing there to include in the index. I am going to guess that the number of firms on the index pre-depression that are still there is small.
As far as the impact on the value of the Dow, the DJIA lost value of the index over the last decade as GM has been swirling around th bowl. By the time they were dropped they had over time been a drag. Now that the firm essentially has no value it gets dropped and they rebalance the index to the same baseline Including the new firm.
I’ll guess that Wiki has the calculatio or an overview of how they would do it.
The point of the index is to create a proxy for tracking the performance of diversified firms that are significant contributors to the economy. Over time the losers need to fall out and be replaced by firms in industries that are growing.
30 stocks are a crap way of measuring market progress or for diversifying investment, S+P 500 is a much better index. Works the same way, but targets holding the top 500 companies in the US (by market cap I think)…
From wiki:
The Dow Jones Industrial Average (NYSE: DJI, also called the DJIA, Dow 30, INDP, or informally the Dow Jones or The Dow) is one of several stock market indices, created by nineteenth-century Wall Street Journal editor and Dow Jones & Company co-founder Charles Dow. It is an index that shows how certain stocks have traded.[1] Dow compiled the index to gauge the performance of the industrial sector of the American stock market. It is the second-oldest U.S. market index, after the Dow Jones Transportation Average, which Dow also created.
The average is computed from the stock prices of 30 of the largest and most widely held public companies in the United States. The “Industrial” portion of the name is largely historical. Many of the 30 components have little or nothing to do with traditional heavy industry. The average is price-weighted, and to compensate for the effects of stock splits and other adjustments, it is currently a scaled average. Not the actual average of the prices of its component stocks, but rather the sum of the component prices divided by a divisor, which changes whenever one of the component stocks has a stock split or stock dividend, so as to generate the value of the index. Since the divisor is currently less than one, the value of the index is higher than the sum of the component prices.
To calculate the DJIA, the sum of the prices of all 30 stocks is divided by a Divisor, the Dow Divisor. The divisor is adjusted in case of stock splits, spinoffs or similar structural changes, to ensure that such events do not in themselves alter the numerical value of the DJIA. Early on, the initial divisor was composed of the original number of component companies; which made the DJIA at first, a simple arithmetic average. The present divisor, after many adjustments, is less than one (meaning the index is actually larger than the sum of the prices of the components). That is:
where p are the prices of the component stocks and d is the Dow Divisor.
Events like stock splits or changes in the list of the companies composing the index alter the sum of the component prices. In these cases, in order to avoid discontinuity in the index, the Dow Divisor is updated so that the quotations right before and after the event coincide:
The Dow Divisor is currently 0.132319125.[13][14] Presently, every $1 change in price in a particular stock within the average, equates to a 7.56 point movement.
The Dow unfortunately is used by the financial networks and newspapers, but it is a deeply flawed index, for the reasons noted above.
The S&P 500 is a far superior index to the Dow Jones 30 for most purposes. The S&P 500 does, however have a ‘success-bias’, as its market-cap weight system puts a higher weight on stocks with a higher market cap (product of common shares times current price per share). This is well illustrated by its growth-bias (and technology-sector bias) in the 21997-2000 dot-com bull market.