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Why is Dow getting a makeover?

NEW YORK – 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 is 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.

What is the Dow?

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 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.

Who gets in the Dow?

It’s an elite club. The Dow’s members often are 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 through the years.

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

How does this affect my investments?

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: 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 news 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.”

Why are Bank of America, Hewlett-Packard and Alcoa being removed?

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 such as IBM and 3M.

Why are Goldman Sachs and Visa being added?

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 actually is a giant technology company focused on payment processing. Replacing HP with Visa is, in a way, a replacement of one technology company with another.

Apple and Google are huge companies. Why didn’t they get picked?

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, about 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 a $900 share of Google, which is worth $295 billion.

Does the Dow’s makeup change often?

Not usually. 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.

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