Hi everyone, it’s Virtual Dan! You may have heard the news that the Dow Jones Industrial Average is going to be reshuffling its deck on August 31, 2020. That’s right, I’ve spoken quite a bit about stock market indexes trying to help everyday folks understand some of this Wall Street jargon so you know what you are investing in.
Let’s start with a brief recap of what the Dow Jones Industrial Average index is and how it’s constructed…
Two business partners created the Dow Jones Industrial Average in 1896; they were Charles Dow and Edward Jones. They created the Dow Jones Industrial Average to make it easier to understand the movement of the stock market over any particular period of time.
So how is the Dow constructed today? It’s a price-weighted index – which is quite a bit different than the S&P 500 and many other indexes that are market cap weighted.
Price weighted means that member companies are weighted by stock price. The higher the price per share, the higher percentage weighting to the movement of the index.
Market cap weighted means that member companies are weighted by market capitalization (price x number of shares). The higher the total market capitalization, the higher percentage weighting to the movement of the index.
Understanding how a price-weighted stock index works is important because it’s exactly why next week’s reshuffling of the Dow Jones Industrial Average is happening in the first place.
Current Dow Jones Industrial Average components and the percentage they represent of the Dow (as of August 25, 2020):
- United HealthCare 7%
- Home Depot 7%
- Microsoft 5%
- McDonald’s 5%
- Goldman Sachs 5%
- Visa 5%
- Boeing 4%
- 3M 4%
- J&J 3%
- Caterpillar 3%
- P&G 3%
- Walmart 3%
- Disney 3%
- IBM 3%
- Travelers 2%
- Nike 2%
- JP Morgan 2%
- American Express 2%
- Chevron 2%
- Merck 2%
- Raytheon 1%
- Verizon 1%
- Intel 1%
- Coca-Cola 1%
- Dow Inc 1%
- Exxon Mobil 1%
- Cisco Systems 1%
- Walgreens <1%
- Pfizer <1%
Clearly we can see by just looking at the structure of the Dow Jones Industrial Average that there are some quirky parts to it. For instance, currently there are three components that represent 5% of the index each; they are Microsoft, McDonalds, and Goldman Sachs.
Now let’s look at their market capitalization, aka the true size of a publicly traded corporation.
- Microsoft $1.636 trillion
- McDonald’s $158 billion
- Goldman Sachs $70 billion
See how vast the true difference in size is, but due to the way the Dow Jones is price-weighted, these three companies have nearly equal representation in the index.
Okay, so now that we are well educated on the structure of the Dow Jones Industrial Average, let’s see why there is a reshuffling coming next week. You may have heard that Apple is completing a stock split next Monday, August 31, 2020. That means that next Monday, the price of Apple stock will immediately change from about $500 per share to about $125 per share. Now the owners of Apple stock will also receive four shares for every one they had, so the market capitalization of Apple (price x number of shares) isn’t changing from $2.13 trillion, since the price divides by four and the share count multiplies by four at the same time.
So when Apple begins trading next Monday post-split at around $125 per share, it will only represent 3% of the Dow Jones Industrial Average like J&J or Caterpillar.
Since Apple’s price change has such a dramatic effect on the overall index, the index needed to be revamped at the same time, more or less a refreshing of the index.
Whose being removed?
- Raytheon (large defense company)
- Exxon Mobil (large oil company)
- Pfizer (large drug company)
Whose being added?
- Honeywell (interesting – this is Honeywell’s second time being included in the index – it was kicked out in 2012)
So now you can see that beginning on Monday, August 31, 2020, United HealthCare will be the largest weighting in the index. The index is meant to represent the overall US economy by including a mix of different industries, etc., to best match the current structure of the US economy.
This also means that any index funds that represent or match the Dow Jones Industrial Average, such as the popular exchange-traded fund (DIA) – Spider ETF, will need to drop Raytheon, Exxon Mobil, and Pfizer while adding in Salesforce.com, Amgen, and Honeywell.
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