The Dow Jones Industrial Average was created in 1882 by Charles Dow.  Contrary to popular belief, the original focus was on 11 growth stocks, and not industrial stocks.  The index originally included 9 railroad stocks, a steamship line and a communications company. In 1896, transportation and industrials were split into 2 averages, one of which was what we now know as the Dow Jones Industrial Average.


To calculate theoriginal index, it was as simple as adding up the prices of the 11 components, and dividing by 11.  But much has changed over the last 127 years since the average was first created.  Component companies have disappeared, new companies have been added, and numerous stock splits have occured.  One thing has not changed, and that is the use of the simple price weighted average.  Only the multiplier has changed to factor in all the component changes.

The Dow Jones today consists of 30 companies.  The multiplication factor used to calculate the average is 7.964782.  For each component, regardless of market cap, the last price is multiplied by 7.964782.  The sum of all these factors is the new average.  There is also an unwritten rule of thumb that states that stocks in the average must be over $10 per share, or risk being removed from the average.  As of this writing, there 4 stocks below $10 (Alcoa, Citibank, General Motors, Bank of America), but they remain in the reported average – for now.

dowjones

Based on the above information, here are a few interesting calculations:

  • If Citibank, General Motors, Bank of America and Alcoa all go to zero, the Dow only drops to 7906.
  • If everything on the left side (Citbank through Merck) go to zero, the Dow only drops to 6146.
  • If everything on the left side loses 20%, the Dow only drops to 7691.
  • If everything on the right side loses 10%, the Dow only drops to 7462
  • If everything on the right side loses 20%, the Dow only drops to 6848.

If you are a bear, keep these figures in mind as you weigh your decisions to bet to heavily against the Dow.

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