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By | May 20, 2012

Dear Toolkit,

Can you help me become an informed investor by explaining how the 30 blue chip stocks that make up the "average" don't add up (or should I say divide up) to whatever the Dow average is on any given day?

Thanks,

Bargain Hunter

Dear Bargain Hunter,

Lesson one: The Dow Jones Industrial Average is neither average nor industrial. It started out as both, but evolved over time.

Actually, when the DJIA was born in 1896 (a little before our time, thankfully) Charlie Dow and Ed Jones picked 12 stocks, added up their per share closing prices and divided by 12 to get the very first day's true average of $40.94. They developed this index to publish in their daily paper, the Customer's Afternoon Letter, which soon morphed into The Wall Street Journal.

The quaint original Dow dozen were American Cotton Oil, American Sugar, American Tobacco, Chicago Gas, Distilling and Cattle Feeding, General Electric, Laclede Gas, National Lead, North American, Tennessee Coal and Iron, U.S. Leather, and U.S. Rubber. (GE's the only one remaining today.)

These original 12 DJIA stocks became 20 in 1916, and then rose to the current 30 in 1928. (The original 12 actually became 65, but were divided up into 30 industrial, 20 transportation, and 15 utility stock categories.) Currently, "industrial" means anything that isn't transportation or utility-related; many of today's 30 are conspicuously non-industrial.

Over the 100 years since the DJIA originated, you will not be surprised to learn that things have changed. And one of the things that has changed is the "divisor" used in computing the "average." In the good old days, life was simple and we didn't have to deal with stock splits and spin-offs and big, juicy dividends goofing up our math. But nowadays we've got to make adjustments for all the modern-day MBAs' meddling in corporate finance.

For example, let's say that Uptite Corset Company shares are $25 each, Acme Buggywhip Co. shares are $50, and Frugal Futon goes for $75. $25 + $50 + $75 divided by 3 = $50. Are you with us so far? Good. Now let's say UCC and ABC stay the same but the beancounter at FF thinks this would be a good time for a 3-for-1 stock split. So now we have $25 + $50 + $25 (FF's new price) divided by 3 (because we still only have 3 companies, right?) So our "average" has become $33, which doesn't correctly represent the value of the investments and, when compared to yesterday's average of $50, looks like the bears have arrived.

So what's a beancounter to do to get historical continuity back into the average? Changing the divisor is one way to do it and it's definitely the DJIA way. The idea is to compensate by changing the divisor to whatever number will get the new average close to the pre-split average.

In our example, we'll change it to 2. $25 + $50 + $25 (FF's new price) divided by 2 = $50 (our original average.) Of course this is a vastly oversimplified description of how this adjustment is made. Several highly overcompensated actuaries are probably required to perform the math magic in real life.

It is well to keep in mind that "the Dow" is just a guidepost, a marker to measure relative change (up or down) rather than the true dollar average it was in 1896. And it's that trend-reading feature that makes it fun to follow. From its humble 1896 beginnings at 40.94, it hit 2000 in 1987. By 1993 the bulls took over and pushed it to 3000, then 6000 in 1996, 8000 in 1997, and shot past 11,000 (briefly) in 1999. (We won't dwell on the subsequent invasion of the bears which plagued us on and off. Of course 9/11 and Iraq took their toll during those interim years until early 2006 when 11,000 did a welcome encore.) In 2007 it topped out well over 13,000, but  crashedin September 2008.

Bet you'd like to know the guys who get to pick these stocks out, wouldn't you? Me too, but the editors of The Wall Street Journal have yet to respond to my request to attend their DJIA selection meetings. They don't change the listed companies very often.

Back in 1991 Disney replaced USX. Maybe the editors were just looking for freebee passes to the Magic Kingdom, but I suspect they also decided that entertainment should be represented as a major industry. That same year Caterpillar replaced Navistar and J. P. Morgan replaced Primerica. Another notable change took place March 17, 1997 when Woolworth, Westinghouse, Texaco and Bethlehem Steel were replaced by Hewlett-Packard, Johnson & Johnson, Citigroup and Wal-Mart.

Effective November 1, 1999 Sears, Union Carbide, Goodyear and Chevron were replaced by Microsoft, Intel, Home Depot and SBC. For the first time in its history, two NASDAQ stocks (Microsoft and Intel) joined 28 traditional NYSE issues on the DJIA.

On April 8th, 2004 Eastman-Kodak, International Paper and AT&T were replaced with AIG, Pfizer and Verizon. Glory is short lived, however, as AIG was replaced by Kraft Foods on September 18, 2008 due to the insurance company's mega meltdown.

On June 8th, 2009 Cisco Systems Inc. and Travelers Cos. replaced General Motors Corp. and Citigroup Inc. GM's bankruptcy filing automatically disqualified it from membership, while Citigroup was removed due to its impending restructuring. GM had been in the DJIA for 83 years. Cisco Systems was chosen to replace GM as computer information based industries are to the current century's makeup as automobiles were in the prior century. Travelers was chosen to replace Citigroup, as the insurance firm is a representative of the financial industry.

You've got to continue to merit your spot on the DJIA. IBM found that out when it got replaced in 1939 by AT&T and it took them until 1979 to redeem themselves and get back into that exclusive club. The current DJIA list includes consumer-oriented companies such as McDonald's and Coca-Cola, along with the usual heavy industries like General Motors and Exxon, and I'm sure we'll be seeing more "Information Age"-related changes in the years to come.

(Just for the record, the rest of the list includes Alcoa, Boeing, Merck, Procter & Gamble, United Technologies, Philip Morris (now called Altria Group), 3M, DuPont, Honeywell and American Express.)

While the venerable DJIA is far from the most accurate index, it is the oldest and most commonly used. The S&P 500 and 100, the NYSE 1500, and the NASDAQ Composite and the Russell 2000 are but a few of the too-numerous-to-count, mathematically superior measures of market activity. But the Dow's long track record keeps it ahead of its more accurate competitors with investors throughout the world. And for the most part, most of these indexes move in concert regardless of whether they're "unweighted" like the Dow or "weighted" (price multiplied by outstanding shares) like the many other popular indexes.

While "the Dow" may not be a model of mathematical precision and it's certainly not a list of trendy "hot stocks," this fine old institution will survive and likely prevail long into the 21st century with Rupert Murdoch driving the bus. Let's just hope we'll do as well.

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