The Dow Industrials is a price-weighted index, which means that the
prices of the component stocks are added together and then divided by
the number of firms in the index. As a result, proportional movements of
high-priced stocks in the Dow averages have a much greater impact
than movements of lower-priced stocks, regardless of the size of the
company. A price-weighted index has the property that when a compo-
nent stock splits, the split stock has a reduced impact on the average,
and all the other stocks a slightly increased impact.^3
Price-weighted indexes are unusual since the impact of the firm’s
price on the index has nothing to do with the relative size of the com-
pany. This is in stark contrast to a capitalization-weighted index, such as
Standard & Poor’s 500 Index, which is described later in the chapter. As
of December 2006, the 30 Dow stocks were valued at $4.2 trillion, which
is about 25 percent of the capitalization of the entire U.S. market. Out of
the 10 largest U.S.-based capitalization stocks, all but Bank of America
are in the Dow Industrials. But not all the Dow stocks are large. Two
Dow stocks are not even in the top 100: Alcoa and General Motors. And
the smallest, General Motors, is ranked below 200 and has about 4 per-
cent of the market value of Exxon Mobil, which is the largest component.
Long-Term Trends in the Dow Jones
Figure 3-1 plots the monthly high and low of the Dow Jones Industrial
Average from its inception in 1885, corrected for changes in the cost
of living. The inset shows the Dow Industrial Average uncorrected for
inflation.
Atrend lineand a channelare created by statistically fitting the Dow
on a time trend. The upper and lower bounds are 1 standard deviation,
or 50 percent, above and below the trend. The slope of the trend line, 1.85
percent per year, is the average compound rate at which the Dow stocks
have appreciated, excluding inflation, since 1885. The Dow Jones aver-
age, like most other popular averages, does not include dividends, so
the change in the index greatly understates the total return on the Dow
stocks. Since the average dividend yield on stocks was about 4.3 percent
during this time, the total annual real compound return on the Dow
stocks was 6.2 percent over this period, a bit below the long-term real
stock return reported in Chapter 1.
40 PART 1 The Verdict of History
(^3) Before 1914, the divisor was left unchanged when a stock split, and the stock price was multiplied
by the split ratio when computing the index. This led to rising stocks having greater weight in the
average, something akin to value-weighted stock indexes today.