By the Blouin News Business staff

The Dow evolves — and endures

by in U.S..

Dow Jones Industrial Average shown on TV screen

Photo Credit: Getty Images: Mario Tama

One of the quirks of the Dow Jones Industrial Average is that there were no recognizable industrial stocks in its precursor. Nine railroad companies, a steamship line and a communications company comprised Charles Dow’s first 11-stock Dow Jones Average in 1884. It wouldn’t be split into an Industrial Index (which would become known as “the Dow”) and a Railroads, later Transportation, Index until 1896. Difficult as it might be to imagine now, Dow’s vision of differentiating the stock market’s long-term trends from short-term price fluctuations was revolutionary.

Today’s announcement of the latest change to the Dow’s constituents — Goldman Sachs, Nike, Visa in; Bank of America, Alcoa, HP out as of September 23 — provides a reminder of the idiosyncrasies of the iconic index. The biggest is that it is price-weighted. The share prices of its constituents are added up and divided by the number of its constituents, adjusted to take account of events like stock splits.

These days the Dow comprises 30 stocks that are considered to be the leaders of the U.S. economy. Its virtue is that it is simple. Its vice is that it gives a snapshot of the health of the U.S. economy through the particular lens of a selection of big, albeit frequently traded companies. While the Dow is the popular shorthand for “the market”, professional investors pay more attention to the S&P 500, a broader index weighted by its constituents’ market capitalization.

The issue with a price-weighted index is that a $1 change for a $10 stock is much more significant in percentage terms than a $1 change for a $100 stock, with the commensurate effect on the index’s performance. That is one reason that the Dow’s constituents get changed periodically (General Electric is the only original Dow constituent still in the index).

The three stocks that are getting ejected in this go-round are the three with the lowest price (which pulls the average down). But they have not been replaced with three of the most expensive stocks, such as Apple or Google. That would over inflate the index in the opposite direction by giving the priciest stocks disproportionate weight in the calculation. Nonetheless, at current prices, Visa and Goldman will be the second and third most important stocks in the index.

Selecting 30 stocks to reflect the ever-changing nature of the U.S. economy provides for another quirk. Constituent stocks are not selected on the basis of a set of rules, as is the case for most widely followed indexes, but picked by a committee that includes editors of the Wall Street Journal.

Regardless, Goldman Sachs, Visa and Nike — investment banking, credit cards and trainers — do seem, intuitively, more representative of the modern U.S. economy than Bank of America, Hewlett-Packard and Alcoa. The same could be said of the addition of AIG, Verizon and Pfizer in place of Eastman Kodak, International Paper and AT&T in 2004, the last three-for-three change. And of the replacement of Mondelez International (nee Kraft Foods) by UnitedHealth last year, the previous change.

Tellingly, little by way of investment assets is benchmarked against the Dow. Yet more than 32,000 daily calculations since Charles Dow did his first division and came up with 40.94 at a time when the stock market was not held in high public regard (plus ça change), the average that has outlived him by more than a century continues to evolve — not just the oldest, but arguably the most iconic and watched stock indicator in the world.