Understanding the Theoretical Dow Jones Index: A Deeper Look

What Is the Theoretical Dow Jones Index?

The theoretical Dow Jones Index uses averages of the high and low price for each equity in the index in its daily calculations rather than the index components' closing prices. This methodology implies all stocks hit their high and low points simultaneously, a rare occurrence in reality. However, this method for calculating the Dow Jones Index provides a better snapshot of where the index traded, on average, during market hours.

The theoretical Dow Jones Index should not be confused with the Dow Theory, a financial theory that predicts the market is in an upward trend if one of its averages advances above a previous important high, accompanied or followed by a similar advance in the other average.

Key Takeaways

• The theoretical Dow Jones index computes the daily price of the Dow Jones Industrial Average by taking the average of each component's daily high and low price.
• This methodology was used mainly prior to 1992.
• Nowadays, the Dow Jones Industrial Average (DJIA) prices are updated every 10 seconds and available for quotation throughout the day.

Understanding the Theoretical Dow Jones Index

The theoretical Dow Jones provides a proxy for the amount of market movement that took place for the index via additional calculations made on the high and low prices of each stock. However, these daily snapshots imply that all stocks hit their high and low points simultaneously. A snapshot of the index at its actual low point and high point of the day would likely fall short of the theoretical marks in reality, with theoretical highs higher than the actual high points and theoretical lows lower than the actual low points over the course of a trading day.

The DJIA's weighting scheme requires a snapshot of the prices of the underlying stocks, however. Tracking daily movements and other metrics, such as highs and lows for the index, accurately requires a set of snapshots throughout the day. Before 1992, those snapshots were not readily available. However, the published daily metrics for each stock in the index, including open, close, high, and low, provided a relatively easily calculated, rough idea of the movement of the index on a given day.

History of the Dow Jones Industrial Average Calculation

Charles Dow and Edward Jones founded the Dow Jones Industrial Average in 1896, including 12 companies they felt broadly exemplified the strength or weakness of the nation’s stock market. The index weights the price of each stock by its proportion to the overall index, which changes the calculation of the index subtly for any fixed point in time. In other words, a stock with a higher share price gets greater weight in the overall calculation of the index.

The Dow Divisor is the numerical value used to calculate the level of the DJIA. Essentially, the DJIA is calculated by adding up all the stock prices of its 30 components and dividing the sum by the divisor. However, the divisor is continuously adjusted for corporate actions, such as dividend payments and stock splits.

The index also changes over time as stocks get included in or excluded from the index, and as other events such as mergers or stock splits affect the number and price of shares covered by the index. These adjustments allow for a smoother comparison of the price of the index over time, even as it obscures the relationship between the actual price of the equities in the index and the value of the index itself.