The interesting thing about that big decline is that nearly half of the movement on that day can be attributed to a drop in just one of the thirty stocks which comprise the average, VISA (V). In fact, on that day, eight of the stocks in the average, more than one quarter of them, actually increased in price, and the aggregate price changes of the other 29 companies would have caused the Dow to drop by only 73 points. VISA made the difference between just a run-of-the-mill down day and the perception of a bad day.
How can that be? How can one stock have such a huge impact on the average, the benchmark that most news outlets use as their benchmark for the entire market?
The answer lies in the way that the average is calculated. The Dow Jones Industrial Average is a simple average. It is not weighted for prices or market capitalization like the NASDAQ average is. The simple calculation methodology means that equal percentage moves in various stocks have disparate impact on the average, based on the price of the stock, which we'll see in a moment.
First, let's look at how the average is calculated. Back in 1896, when Charles Dow created the average which still bears his name, he simply added up the prices of thirty large industrial stocks of the era and then divided by thirty. It is exactly the way we all learned to calculate averages in elementary school (statisticians call this an "arithmetic mean."), and it had the same flaws when Dow first published it as it does today, that more expensive stocks impact movement in the average more than cheaper securities do, but, again, we'll get to that in a moment.
While Dow started out dividing by thirty, as time passed, that divisor had to change. In order to maintain consistency of the number for comparability over time the divisor had to be adjusted to allow for things like stock splits and changing of component stocks in the average. For example, say that one of the companies in Dow's original list underwent a four-for-one stock split, reducing its share price from $120 to $30. This would cause the sum of the prices of the thirty stocks to be $90 less than it was pre-split. If Dow had continued to divide the sum of the prices of his stocks by 30 was maintained, then his average would have fallen by three points even though no wealth been lost by any investor. In order to make sure that values from Dow's average were comparable from one day to the next, he had adjust the divisor, in this example, from 30 down to 28.8 in order to make sure that his average was consistent.
In a similar manner, changes in the company composition of the average also caused the divisor to change. Replace a low-priced company with a more expensive company, and the divisor must be increased; replace an expensive stock with a cheaper one, and the divisor decreases. Over the past 100 years, the predominant trend of the changes has been to decrease the divisor, mostly due to stock splits, to the point that the divisor eventually (in 1986) fell to near one, and then declined below it. The current divisor, as of April 25, 2014, is 0.155715905, which means that every one dollar change in any of the Dow Stocks cause the average to move by 6.42 points (1 / 0.155715905).
And that's how we get the imbalance. Take a look at the thirty stocks which currently comprise the DJIA, along with their closing prices on April 25 and the day's change for each, represented in terms of dollars and a percentage:
Close
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Change
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Pct
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| AXP | American Express Co | 87.03 | -0.38 | -0.4366% |
| BA | Boeing Co | 128.66 | -1.20 | -0.9327% |
| CAT | Caterpillar Inc | 104.69 | -0.59 | -0.5636% |
| CSCO | Cisco Systems Inc | 23.00 | -0.33 | -1.4348% |
| CVX | Chevron Corp | 123.99 | -0.31 | -0.2500% |
| DD | E I du Pont de Nemours and Co | 66.66 | -0.45 | -0.6751% |
| DIS | Walt Disney Co | 78.23 | -1.36 | -1.7385% |
| GE | General Electric Co | 26.60 | 0.14 | 0.5263% |
| GS | Goldman Sachs Group Inc | 158.24 | -2.61 | -1.6494% |
| HD | Home Depot Inc | 79.38 | -0.39 | -0.4913% |
| IBM | International Business Machines Co... | 189.63 | -0.59 | -0.3111% |
| INTC | Intel Corp | 26.26 | -0.49 | -1.8660% |
| JNJ | Johnson & Johnson | 99.79 | -0.17 | -0.1704% |
| JPM | JPMorgan Chase and Co | 55.70 | -0.49 | -0.8797% |
| KO | The Coca-Cola Co | 41.01 | 0.31 | 0.7559% |
| MCD | McDonald's Corp | 100.73 | 0.89 | 0.8836% |
| MMM | 3M Co | 136.56 | -0.09 | -0.0659% |
| MRK | Merck & Co Inc | 57.24 | -0.29 | -0.5066% |
| MSFT | Microsoft Corp | 39.91 | 0.05 | 0.1253% |
| NKE | Nike Inc | 72.70 | -0.69 | -0.9491% |
| PFE | Pfizer Inc | 30.75 | 0.04 | 0.1301% |
| PG | Procter & Gamble Co | 81.41 | 0.26 | 0.3194% |
| T | AT&T Inc | 34.49 | -0.01 | -0.0290% |
| TRV | Travelers Companies Inc | 88.31 | -0.28 | -0.3171% |
| UNH | UnitedHealth Group Inc | 75.66 | -0.93 | -1.2292% |
| UTX | United Technologies Corp | 117.21 | -1.77 | -1.5101% |
| V | Visa Inc | 198.93 | -10.47 | -5.2632% |
| VZ | Verizon Communications Inc | 45.94 | -0.34 | -0.7401% |
| WMT | Wal-Mart Stores Inc | 78.62 | 0.31 | 0.3943% |
| XOM | Exxon Mobil Corp | 100.41 | 0.40 | 0.3984% |
| 2547.74 | -21.83 | -0.8568% |
Note that VISA is the most expensive stock in the list, nearly $200 per share (three years ago, I owned VISA, and sold it for $88 per share when I got spooked, but that's another story). VISA shares declined over $10, which was over 5% of VISA's value. That $10.47 change, when divided by the current Dow divisor, means that this stock had an impact on the average of -67.24 points.
Now, say for example that Cisco Systems (CSCO) had suffered a decline of the same magnitude as VISA's plummet. Cisco's stock would have fallen $1.23, from its opening price of 23.33 down to $22.10. But, the same divisor calculation means that the Dow Jones average would have fallen only 7.89 points. Cisco's shareholders would have endured a financial loss of 5.26% in the value of value of their position, identical to the pain suffered by VISA's shareholders on Friday, but Cisco's pain would have barely dented the Dow Jones average.
