The Dow Jones Industrial Average (DJIA) of 30 large, “blue-chip” corporations has been
computed since 1896. Its long history probably accounts for its preeminence in the public
mind. (The average covered only 20 stocks until 1928.)
Originally, the DJIA was calculated as the average price of the stocks included in the
index. Thus, one would add up the prices of the 30 stocks in the index and divide by 30.
The percentage change in the DJIA would then be the percentage change in the average
This procedure means that the percentage change in the DJIA measures the return
(excluding dividends) on a portfolio that invests one share in each of the 30 stocks in the
index. The value of such a portfolio (holding one share of each stock in the index) is the
sum of the 30 prices. Because the percentage change in the average of the 30 prices is
Because the Dow corresponds to a portfolio that holds one share of each component
stock, the investment in each company in that portfolio is proportional to the company’s
C H A P T E R
2
Asset Classes and Financial Instruments
45
Consider the data in Table 2.3 for a hypothetical two-stock version of the Dow Jones
Average. Let’s compare the changes in the value of the portfolio holding one share of
each firm and the price-weighted index. Stock ABC starts at $25 a share and increases to
$30. Stock XYZ starts at $100, but falls to $90.
Portfolio: Initial
value
5
$25 1 $100 5 $125
Final value 5 $30 1 $90 5 $120
Percentage change in portfolio value 5 2 5/125 5 2 .04 5 2 4%
Index:
Initial index value 5 (25 1 100)/2 5 62.5
Final index value 5 (30 1 90)/2 5 60
Percentage change in index 5 2 2.5/62.5 5 2 .04 5 2 4%
The portfolio and the index have identical 4% declines in value.
Notice that price-weighted averages give higher-priced shares more weight
in determining performance of the index. For example, although ABC increased
by 20%, while XYZ fell by only 10%, the index dropped in value. This is because
the 20% increase in ABC represented a smaller price gain ($5 per share) than the
10% decrease in XYZ ($10 per share). The “Dow portfolio” has four times as much
invested in XYZ as in ABC because XYZ’s price is four times that of ABC. Therefore,
XYZ dominates the average. We conclude that a high-price stock can dominate a
price-weighted average.
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