Thursday, March 21, 2013

Taking Stock (Please Pay For It First)

Yesterday, the Dow Jones closed at 14,511.

Okay, great. 14,511 what? You've probably asked that at some point. I've seen Stephen Colbert ask it a couple times. What exactly are we measuring here? Let's cover that today.

It's actually pretty simple. Well, relatively simple. If you've got a calculator on hand that displays a whole lot of digits. The Dow Jones Industrial Average starts off by simply adding up the prices of the 30 stocks in its index. Then it applies a multiple, called the Dow Divisor. That's it. At the outset of the Dow, it was even simpler: there were 11 stocks in the index, so you added up their prices and divided by 11. The Dow Divisor changes regularly, to compensate for changes to each of the stocks such as splits, dividends, and whatnot. (After all, if a stock splits in half- thus halving the price of a stock- and that isn't reflected somehow, it's going to result in an erroneous Dow crash and panic on Wall Street for no good reason.) Currently, the Dow Divisor is 0.130216081. Translated, that means for every dollar change in a Dow stock's price, the index moves by 7.68 points. An index reading of 14,511 would mean that, added up, one share of each stock in the Dow would run you $1,889.45.

Well, that was simple. So why stop there? Let's keep going. Not like the Dow's the only index out there.

The Standard and Poor 500, like a lot of exchanges, works on the principle that the Dow misses something rather important: a dollar change in Company A's stock price may not mean the same thing as a dollar change in Company B's stock. A stock going from $1 to $2 means something different from one going from $37 to $38. The Dow doesn't account for that. What the S&P 500 measures is weighted total market value, again applied to a divisor- something all stock indices have- that's altered based on various factors. The weighting, as of 2005, is based on how many shares of each stock are made available for public trading. The more shares you put out there for trading, the more weight your stock has in the index. (Splits don't change the total value of the stocks on offer, so that's not calculated in the divisor.) So you can put away the calculator; that's not going to help you here. Also in play is a 'base period', which most indices use. A base period is a point in time that the index is measuring itself against. In the case of the S&P 500, the period of 1941-43 is used as the base, and the value of the index at that time has been set at 10. (For the Dow, the base period is May 26, 1896, and the base value is 40.94.)

Last, we'll do the NASDAQ exchange, which gets confused a bit. There are two indices that get followed. There's a limited index- the NASDAQ 100- and then there's the one you hear about on the news, the NASDAQ Composite, simply called 'the NASDAQ', which incorporates every stock on the exchange, which works out to somewhere in the neighborhood of 3,000 stocks. Both use a weighted-market-cap format, like the S&P 500. The NASDAQ 100 has a caveat that forces them to reweight the companies when domination takes hold. If a company ends up being worth over 24% of the index, the index is reweighted. If the companies with at least 4.5% weight find themselves in control of over 48% of the index, the index is reweighted. When the index is reweighted, all companies are given equal weight. As it stands, the base period is January 1, 1994, which is valued at 125 points.

The NASDAQ Composite has no reweighting mechanism. Since every company on the exchange is in the index, and since any company on the exchange can go bust at any time- the NASDAQ is a tech-heavy exchange, so this can happen even faster than it can in a normal index- the exchange has to play gatekeeper and have some standards implemented to even list a stock. The base here appears to be February 5, 1971, which is valued at 100 points. (The New York Stock Exchange also has a composite index which works the same way. It's based to January 2003 at 5,000 points.)

We'll leave it at the major American exchanges. You don't need to be sitting here reading about the exchanges in Chicago and Philadelphia. And Boston. And Phoenix.

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