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Wall Street's prime number; As a financial yardstick, the Dow Jones Industrial Average is somewhat of an anachronism, but it has its fans; For the record

THE BALTIMORE SUN

It is mysterious and imprecise, misnamed and arbitrary. But through boom times and depression, through its recent record-breaking gains and wild fluctuations, it remains the most widely recognized and religiously followed barometer of the U.S. stock market.

For those unversed in the ways of Wall Street, it is something of an enigma. For many savvy investors, it is a lumbering and antiquated construct. But it has held a prominent place in the world of finance for more than a century, longer than any other number of its kind.

But just what is this thing called the Dow Jones Industrial Average?

It is a number derived from adding and dividing the daily high share price of 30 high-grossing, "blue chip" companies. Thus it offers a yardstick -- or maybe mood ring -- by which to gauge the health of the U.S. stock market. But it is no longer an "average" by any real definition. Nor is it truly "industrial"; only about a third of the companies it lists represent the smokestack-and-heavy-machinery sector of the economy that once dominated it. Even the "Jones" in its name is a questionable addition.

The Dow got its start after Charles Henry Dow co-founded the publishing company Dow Jones & Co. in 1882 with the aid of fiery-tempered business reporter Edward Davis Jones and the funding of colleague Charles M. Bergstresser.

In 1884, in an edition of his Customer's Afternoon Letter, a two-page daily paper that would eventually grow into the Wall Street Journal, Dow chose 11 of the most successful industrial companies he felt represented the late 19th century economy (nine were railroads). He added the prices of a stock share for each and divided by 11, giving Afternoon Letter readers a quick reference point on how the nation's biggest publicly traded companies were doing. Twelve years later, he reworked his average, this time with a total of 12 companies, and named it the Dow Jones Industrial Average, linking Jones' name with it forever. (Bergstresser, unfortunately cursed with an unwieldy name, never received any credit he might have been due.)

Since then, the Dow has grown to a list of 30 companies, and is reworked regularly, with new companies added and others cast aside. Now as then, the editors of the Wall Street Journal reign as the Dow's high priests.

Fewer smokestacks

The "industrial" portion of the Dow's name has become increasingly anachronistic. Additions like McDonald's and Disney, Wal-Mart and Home Depot, Hewlett Pack-ard and Microsoft are a far cry from the primary producers who populated Dow's first Top 12, companies like American Cotton Oil, National Lead and Tennessee Coal & Iron. Only General Electric remains from the original list (although it has been removed and restored twice itself).

The addition of tech giants Intel and Microsoft in November 1999 -- replacing Chevron and Union Carbide chemicals respectively -- was unprecedented. Though adding these two high-grossing international companies may have seemed overdue, they were the first non-New York Stock Exchange companies ever listed, ending the Dow's traditional snub of the smaller, tech-based NASDAQ companies.

So, the Dow Jones Industrial Average has little to do with Jones and increasingly less to do with industry. Now let's try to decipher what is meant by "average."

A journalist through and through, Charles Henry Dow was neither a financier nor a mathematician. When he created the Dow, it was a simple, price-weighted average. He added the prices of one share for each of his original "top" companies and then divided by the number of companies: 12. Such a formula couldn't account, for instance, for the differing values of stocks being added and subtracted from the list, or for what are called stock splits, occasions when a company splits its stock, usually in half. Shareholders get twice as many shares, but at only half the price.

Simply figuring a new higher or lower stock price into Dow's basic equation without adjusting for the difference would greatly alter the average. So Journal editors came up with a new concept for the divisor, hoping to better reflect market complexities and retain "historical continuity."

As a result, over the years, the one-time divisor of 30 has shrunk ever smaller. Today, it resides at around 0.20145268, which explains in part how an "average" of 30 stock prices ranging from around 20 to nearly 150 could possibly equal 11,000.

A quirky institution

There are other oddities to the Dow. For one thing, the index never actually reaches its published daily high. That's because the formula includes the highest price of each of its component stocks over the period of a day, not necessarily its closing price. Also, the Dow's small scope and focus on behemoth corporations is mostly unheard of in the world of stock indexes. Germany's DAX index also includes just 30 major stocks, but almost all other popular market barometers -- the Standard & Poor's 500, the Russell 1000 and the Wilshire 5000 among them -- have at least a hundred companies represented, and don't adhere to the Dow's "blue chip" mantra.

Some investors say size does matter, calling the Dow anachronistic and obsolete as a market gauge. They link its popularity and prominence solely to its longevity. Others, however follow the Dow as religiously as others follow its Japanese phonetic cousin, the philosophy of Tao.

Investors -- which today include everyone from Internet entrepreneurs to janitors with mutual funds -- have watched it climb from a measly 40.94 in 1896 to nearly 300 times that today. They have seen it weather bucks and dips and the sort of boomerangs the Justice Department and Microsoft set off last week. And for better or worse, it has been there to help map out some of the defining moments of almost half of the country's history.

John Roque, contributor to the online financial magazine TheStreet.com, perhaps captured it best when he wrote sarcastically but fondly of the Dow:

"I love the simplicity of this exercise. ... It is a pure search, one solely seeking what's moving; it eliminates indicator work that often obscures important stock action; and it gives me time to work on more important things, such as learning the names of the dinosaurs that lived during the Cretaceous period so I can teach them to my kids."

The Dow Jones divisor

How the keepers of the Dow Jones Industrial Average determine the value of the stock index's ever-changing divisor, as explained by Dr. Lisa Fairchild, associate professor of finance at Loyola College:

Suppose a hypothetical Dow contains three stocks: A, B and C. Today's prices are as follows: A = $28, B = $35, and C = $19. To calculate the Dow average, add the stock prices and divide by 3: ($28 + $35 + $19)

3 = 27.33 points.

Say then that Stock B splits. Its new price per share would become half of $35, or $17.50. To adjust for the major change in the value of Stock B -- so the next day's Dow doesn't incorrectly appear to have plunged -- a new divisor (d) must be calculated. This is done by dividing the day's total -- adjusted for the stock split -- by that day's average: ($28+$17.50+$19)

27.33 = d, or 2.36.

With the new divisor, the Dow can now be calculated from the next day's prices, when A = $30, B = $18, and C = $21. The new formula: Dow = ($30 + $18 + $21)

2.36, or 29.24 points.

Instead of dropping down to 23, as it would have if the divisor had remained at 3, the point value of the Dow goes up, reflecting the market trend.

The divisor changes every time a Dow stock splits or shares of a new company added to the list differ in value from one deleted.

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