Why the Dow is getting a makeover

[September 11, 2013]  NEW YORK (AP) -- The barometer of America's stock market -- the Dow Jones industrial average -- is getting a makeover.

Alcoa, Bank of America, and Hewlett-Packard are being dropped from the index of America's 30 top companies and replaced by Goldman Sachs, Nike, and Visa.

It's the index's biggest change in almost a decade. The switch up, which will take effect Sept. 23, is due to the falling stock prices of the removed companies and a need to more accurately represent the U.S. economy.

Here is how the Dow works and what the changes mean.

Q: WHAT IS THE DOW?

A: The Dow Jones industrial average is the most popular gauge of the health of the stock market and U.S. economy. It was created in 1896 by Charles H. Dow, one of the founders of The Wall Street Journal, with the intention of giving the stock market credibility and making investing more understandable. The original index had 12 members. The number of companies making up the Dow gradually increased to 30 in 1928.

The index includes some of the biggest household names: Microsoft, American Express, Wal-Mart and General Electric, which has been in the index since 1907.

The index is calculated and published by S&P Dow Jones Indices, a joint venture owned by McGraw-Hill, CME Group and Dow Jones. A small committee decides which companies are added to or dropped from the Dow.

Q: WHO GETS IN THE DOW?

A: It's an elite club. The Dow's members are often referred to as "blue chip" stocks and entry into the index is reserved for a company that "has an excellent reputation, demonstrates sustained growth and is of interest to a large number of investors."

Because the Dow has only 30 members, compared with the 500 members of the Standard & Poor's 500 index, entry is limited. The committee that decides who joins the Dow tries to pick companies that best represent the makeup of the economy.

The economy has shifted away from heavy manufacturing in recent decades, and so has the index. More and more members have come from finance and technology industries over the years.

After Alcoa leaves later this month, the "industrial" makeup of the Dow will slip to 19 percent from 22.2 percent. Technology also represents 19 percent of the Dow, while health care represents 16 percent.

Companies such as UnitedHealth Group, Pfizer and Merck have joined the index in recent years. Financials have become a larger part, too.

Q: HOW DOES THIS IMPACT MY INVESTMENTS?

A: Simple answer: It doesn't. Very few investors actually structure their portfolios around the Dow. Most prefer to use the S&P 500, which is a far broader representation of the market than the Dow.

More funds and more money chase after the S&P 500 than any other U.S. stock index. Some 1,338 funds worth $3.087 trillion track the S&P, according to data from Morningstar. The Dow, by contrast, has six funds worth $195.5 million.

However, Wall Street traders and the media refer to the Dow because it's easier to understand than the S&P 500. When someone says "the Dow lost 200 points," it resonates better than "the S&P 500 lost 20 points."

And the Dow, despite its flaws and lack of funds attached to it, generally tracks the S&P 500 well over the long term. The Dow is up 35.1 percent over the last five years, while the S&P 500 is up 35.3 percent.

The latest changes won't disrupt the level of the Dow, which closed up 128 points to 15,191.06 on Tuesday. The Dow is 467 points, or 3 percent, below its record closing high reached on Aug. 2.

Q: WHY ARE BANK OF AMERICA, HEWLETT-PACKARD AND ALCOA BEING REMOVED?

A: Low stock prices are the primary reason for their removal, along with a need to better represent the makeup of the U.S. economy.

The Dow is a price-weighted average, which means that the higher the stock price, the more influence the stock has over the index's level. Bank of America, HP and Alcoa were the lowest-priced stocks in the Dow, so their movements did not impact the index as much as higher priced members like IBM and 3M.

Alcoa, Bank of America, and HP are still quality companies and remain in the S&P 500 index -- which is a broader gauge of the U.S. stock market.

Q: WHY ARE GOLDMAN SACHS AND VISA BEING ADDED?

A: Goldman Sachs replaces Bank of America, so the Dow is swapping one financial company for another. It's a little different with the Visa-HP trade. While most people think of Visa as a financial company because of its credit and debit cards, Visa is actually a giant technology company focused on payment processing. Replacing HP with Visa is, in a way, a replacement of one technology company with another.

Q: WAIT, ALCOA IS AN ALUMINUM COMPANY AND NIKE MAKES SHOES. THAT DOESN'T MAKE SENSE.

A: There are a few reasons why Alcoa came out of the Dow. First, Alcoa shares were the lowest in the Dow at $8, meaning a movement in Alcoa's stock price would not have affected the Dow as much as IBM or Caterpillar. Secondly, the industry that Alcoa represents -- mining and materials -- only makes up about 3 percent to 3.5 percent of the overall U.S. stock market, says David Blitzer, managing director and chairman of the index committee at S&P Dow Jones Indices.

"We felt Alcoa's slot could be better used for something else," Blitzer says.

Blitzer says the committee felt the Dow had too few consumer discretionary companies in it and there was no apparel representation. Nike is big, well-known and stable. It has a huge business at home and abroad. Nike also trades at $66 a share, helping balance out the Dow.

Q: APPLE AND GOOGLE ARE HUGE COMPANIES. WHY DIDN'T THEY GET PICKED?

A: Apple and Google are too expensive to be in the Dow. Google's stock trades at nearly $900 and Apple shares are around $500, several times more expensive than the Dow's priciest members.

Every change of $1 in any of the 30 Dow stocks moves the index by the same number of points, roughly seven. That gives more sway to companies with higher stock prices. And it's easier for a $100 stock to rise $1 than it is for a $10 stock. (Those numbers will change once the six-company switch happens, but not drastically.)

Apple and Google would have too much weight in the Dow if they were added. The $23 stock price of Intel, a hugely influential technology company valued at $115 billion, would not move the Dow as much as $900 share of Google, which is worth $295 billion.

It's the same reason why Warren Buffett's Berkshire Hathaway, probably one of the most diversified conglomerates in the U.S., is not in the Dow. Berkshire "A" shares trade at $170,000.

This price weighting is one of the Dow's biggest flaws, according to investors. The index's entire formula would need to be restructured to admit high-priced stocks like Apple, Google or Berkshire.

Q: DOES THE DOW'S MAKEUP CHANGE OFTEN?

A: Not usually. Including today, the makeup of the index has changed only 49 times in its 117 year history. The last change to the Dow's membership happened in September 2012, when Kraft Foods was removed and replaced with UnitedHealth. Kraft was pulled because it was breaking into two separate companies, so it wasn't the large food conglomerate it once was.

The index underwent a quick succession of changes during the financial crisis, however. Citigroup, General Motors and AIG were all members at one point. AIG was removed in 2008 when it imploded and required a government rescue. GM, at the time one of the longest-serving members of the Dow, was stripped of its Dow membership when it filed for bankruptcy in 2009. Citigroup was also removed because of the problems it faced during the financial crisis.

The last time three members of the Dow were replaced at the same time was April 2004, when AT&T, Eastman Kodak and International Paper were replaced by AIG, Pfizer and Verizon Communications.

Q: HOW HAVE DOW MEMBERS DONE AFTER BEING ADDED?

A: Since UnitedHealth replaced Kraft, the stock is up 33 percent, more than twice as much as the S&P 500 stock index. In June 2009, Travelers Cos replaced Citigroup and Cisco replaced GM. Since then, Travelers is up more than 100 percent, compared with the 90 percent rise in the S&P 500. Cisco is up 31 percent.

[Associated Press; By KEN SWEET]

Copyright 2013 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.