A small committee decides which companies are added or dropped. David Blitzer, chairman of the index committee, said the changes will bring down the weight of the other 27 stocks in the index and make it a better measure of what's happening in the broader market.
The Dow is a price-weighted index, which means its value is based on the price of a company's stock rather than its market value.
Last September, the index replaced Kraft Foods with health insurer UnitedHealth Group Inc.
General Electric Co. is the only original member in the Dow. The industrial giant was briefly delisted but has stayed in the index since its reinstatement in 1907.
Charles H. Dow created the index with the intention of giving the stock market credibility and making investing more understandable. The original Dow Jones industrial average had 12 members and was published May 26, 1896. It featured companies such as American Cotton Oil, Chicago Gas and U.S. Rubber. What is the Dow Jones industrial average?
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. Dow will make the switches, which take effect Sept. 23, because of the falling stock prices of the removed companies and a need to more accurately represent the economy.
Here is how the Dow works and what the changes mean.
Q: 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.
Q: WHO GETS IN THE DOW?
The Dow's members are often referred to as "blue chip" stocks." 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. Typically, the chosen companies best represent the makeup of the U.S. economy.
The economy has shifted away from heavy manufacturing in recent decades, and so has the index. More members come from finance and technology. After Alcoa leaves later this month, the "industrial" part of the Dow's name will only be 19 percent of the index itself.
At the same time, health care has become a bigger part of the economy, and that's reflected in the Dow. Companies such as UnitedHealth Group, Pfizer and Merck have joined the index. Financials have become a larger part, too.
Q: 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 most 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: HOW COME APPLE AND GOOGLE DIDN'T GET PICKED FOR THE INDEX?
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.
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.
Q: 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 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.
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: 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. 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.