The Dow: Known by all, used by few

Lots of people call the Dow an index, but it's really an average. Photo / AP

Allan Sloan is a seven-time winner of the Loeb Award, business journalism's highest honour. He explains the mind-share phenomenon of The Dow Jones industrial average.

One of the great disconnects of the financial world involves our best-known stock market indicator - the Dow industrials.

The Dow has virtually no investment market share - the $33 billion tied to it as of year-end 2013 is barely a rounding error compared with the $1.87 trillion tied to the S&P 500 - but boy, does it have mind share. Ask "How is the market doing?" and most people (including me) will refer to the Dow, not the S&P.

We will see the mind-share phenomenon at work later this week, with the Dow getting plenty of attention as it adds the world's most valuable company, Apple, after the market closes on Wednesday and kicks out one of the great old names of the past, AT&T. The Dow will go through additional contortions because its highest-priced component, Visa, is splitting its stock 4 for 1. All of this will be in effect when the market opens on Thursday morning.

The S&P - full name, Standard & Poor's 500-stock index - measures the market value of its 500 stocks. But the Dow - full name, Dow Jones industrial average - adds up the prices of its 30 stocks and then divides the total. Lots of people call the Dow an index, but it's really an average. And that makes a huge difference.

For example, some numbers-crunchers at Bloomberg calculated that had the Dow added Apple rather than Bank of America in 2008 and had Apple not split its stock 7 for 1 last year, the Dow would now be about 22,000. (An amusing sidelight: Bank of America replaced Altria just in time to get whacked by the financial crisis; it was ousted from the average in 2013, replaced by Goldman Sachs.)

Although everyone knows the Dow, almost no one invests in mutual funds or exchange-traded funds tied to it.

For reasons I'll explain some other time, each dollar move in any of the 30 Dow stocks moves the average by 6.42195 points. To give you an extreme example, for the Dow, a $1 move by Travelers' 331 million shares is equal to a $1 move in General Electric's 10.04 billion shares. If GE rises a buck and Travelers falls a buck, the S&P, which measures stock market value, would show a $9.7 billion gain. The Dow, by contrast, would be flat.

This bizarre situation helps explain why, although everyone knows the Dow, almost no one invests in mutual funds or exchange-traded funds tied to it. The nation's biggest fund operator, Vanguard, says its investors have about $400 billion tied to the S&P but not a penny tied to the Dow.

Now, let me show you what the Dow has to go through to keep the average at the same level when it changes components or one of its stocks splits.

Let's say that the Apple-for-AT&T substitution and Visa's stock split had taken place after Friday's market close.

The Dow was 17,749.31, and the total market price of its components was $2,763.85. You take that number, add Apple's share price ($123.59), and subtract AT&T's price ($32.76) and $198.77 for the reduction in Visa's share price caused by its 4-for-1 split. You end up with a total of $2,655.91.

To keep the Dow at the same 17,749.31 level, each dollar of stock price would be worth 6.68295 Dow points, rather than the previous 6.42195.

Although this arithmetic is complicated, the public doesn't have to deal with it, and the Dow is really easy for non-investment professionals to understand. "You just add up the prices and divide them," says Howard Silverblatt, senior index analyst at S&P Dow Jones Indices. "The simplicity of the Dow is one of its greatest attributes."

Which is why people will be making such a fuss about the new i-Dow over the next few days. Even though it's totally insignificant.