Plymouth State University
DOW JONES INDUSTRIAL AVERAGE
A description of the model
The Dow Jones Industrial Average (DJIA) is calculated by Dow Jones, Inc. using the following method:
1) Dow Jones selects thirty firms to represent good, large, US companies. This list stays constant, sometimes for years, until such time as Dow Jones replaces a shrinking firm with a growing firm.
2) The shares prices of the thirty firms are added together.
3) Then, the sum of the share prices is divided by a divisor. Common sense would suggest that the divisor would be 30, and further, that dividing by 30 would yield the DJIA. But….
The DJIA isn’t really a mathematical average. It is, instead, an index. The difference is that an average expresses the mean share price of the thirty firms, whereas an index is just a number, a metric that expresses whether share prices are generally going up or down. This difference is illustrated by a hypothetical example of the case in which one firm selling at $20/share is removed from the hallowed list and replaced with a new firm selling at $50/share. The total of the 30 firms’ share prices would have gone up by $30 [50-20=30]. Yet Dow Jones will show a new DJIA exactly equal to the value of the DJIA before the firm switch. They (Dow Jones) keep the index constant by changing the divisor to keep the index constant – that is, constant from immediately before the switch to immediately after the switch.
Over time, since 1889 when Dow Jones started the index, the divisor has changed from 12.000 [originally there were only 12 firms in the index, then 20, now 30] to 0.15571590501117 as of 24 Jan 2014).
4) The model, DJIA=Total/divisor, can be rewritten DJIA x divisor = Total. The rewritten version is used (when the DJIA and divisor are known) to calculate a Total. Then, the Total can be divided by 30 to get an average share price of the 30 firms.
5) As of the close on 24 Jan 2014, the Dow was at 15,879.11 with a divisor: 0.15571590501117
6) The question on the quiz looks like this: The DJIA closed Friday at 15,879.11 with a divisor of: 0.15571590501117. What was the average price per share? [answer: $82.42]
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