Yesterday, the editors of the Wall Street Journal announced that they would replace four of the 30 stocks that comprise the Dow Jones industrial average. Since the four new securities have higher share prices than the stocks they are replacing, won’t the Dow jump in value?
No, because the Dow Jones industrial average is not a true average. It is computed by adding the share prices of the 30 stocks and dividing not by 30, but by a “divisor factor.” This divisor–which is currently 0.197–changes to keep the DJIA from being impacted by stock splits or modifications to the Dow’s composition. For example, if one of the Dow companies splits its stock, the value of each share is cut in half, but the number of shares doubles. Since the value of each investment has not declined, the Dow divisor factor is decreased slightly to ensure that the DJIA remains constant. Similarly, when the new companies are added to the DJIA, the divisor will increase to account for the higher stock prices. So, the Dow level on Monday morning will be the same as its closing value on Friday, even though the constituent stocks will have changed.
(For more on the history and stocks of the Dow Jones industrial average, click here).
