Investments, tenth edition

  Dow Jones Averages 

 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 

price of the 30 shares. 

 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 

the same as the percentage change in the  sum  of the 30 prices, the index and the portfolio 

have the same percentage change each day. 

 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 

share price. Therefore, the Dow is called a    price-weighted  average.      

    2.4 

Stock and Bond Market Indexes 

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  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.