DEFINITION:
The Dow Jones Industrial Average or simply “the Dow” is an index of the 30 largest and prestigious public companies — and it’s used to determine the overall direction of stock prices in general.
Understanding the Dow
The audience always wants to know how does “the market” does in general? Created in 1896 by Charles Dow and Edward Jones, the Dow consists of 30 large “blue chip” U.S. companies chosen by a selection committee. Such companies have to be big, profitable and have a long track record as publicly-traded companies. The Dow index is calculated using a weighted average of those 30 stock prices. So once people are saying that the markets go up, they’re usually making a reference to the Dow. Its ticker symbol is DJIA.
The Dow’s 30 companies are always the most prestigious and very well-known brands in the U.S. Investors always look at the Dow to check how markets are doing at the current moment. It’s important to note that the Dow is price-weighted, so it becomes a bit less useful tool than the S&P 500, which is value-weighted (read more about the S&P 500 in our library). As the Dow depicts only 30 companies, the index shouldn’t be used to evaluate a broader stock market.
Who are the members of the Dow?
If you become a member of the Dow 30, you’re officially a “blue chip” stock. Nowadays, despite its full name, the Dow’s 30 members include industrial and non-industrial companies to show a more inclusive mix of sectors. At the same time, previously, it was made of mainly industrial companies.
There are no quantitative criteria for the “blue chip” club or for those who’re willing to join them. However, there’s a tendency that a company should be U.S. based, have a strong reputation, and perform satisfactorily with sustained growth. In addition, their stock must be listed on the New York Stock Exchange or the Nasdaq. Finally, the selection committee could make changes to the index. |
Although there are no official quantitative criteria for “blue chip” or who gets to join the Dow’s 30-member club, the selection committee looks for US-based companies with an excellent reputation and who’ve demonstrated sustained growth. In addition, it’s a must for them to have their stock listed on the New York Stock Exchange or the Nasdaq. The selection committee changes the index from time to time – recently, as of August 2020, Amgen, Honeywell, and Salesforce.com replaced ExxonMobil, Pfizer, and Raytheon Technologies.
Calculating the Dow
Since it’s a price-weighted index, the stocks with the highest prices of all club members affect the index the most. So, the index is calculated by adding the stock prices and dividing that sum by the “Dow Divisor” number. Long ago, that Divisor was always a constant number. So, it was much easier to calculate the index by simply adding up all the stock prices and dividing by the number of companies included, only 12 at the time.
Undoubtedly, today it gets a bit more complicated. The Dow Divisor appears to be way more complex. The administrator of the S&P Dow Jones Indices determines the Dow Divisor number. By that, ensuring the index remains appropriate and useful over time regardless of various corporate actions. Therefore, the index goes up and down based on the share prices of all 30 members. And the Dow Divisor number changes when there’s a need to adjust the corporate actions and remain more consistent. Nevertheless, one should always remember the main principle, that the companies with a higher share price move the market more.
The differences between the Dow and the S&P 500?
Both the Dow and the S&P 500, with their ticker symbol SPX are used to measure how the stock market is currently doing. However, there’re some crucial differences between the two:
- The number of companies: The Dow is a very exclusive club – it gives prestige to the Dow’s 30 members, while it’s also not that efficient to use it as a tool of measuring the stock market’s overall performance. Of course, you can’t fully estimate the current situation in the market by looking only at the 30largest companies. The S&P 500’s brings it on— it includes 500 companies. Therefore, it’s way more objective than the Dow and could tell you more precisely on “what’s happening with the market today?”
- The way the stocks are weighted: The number you see for the Dow is about 33,200 as of December 2022. That number is calculated by the index method and is based on the 30 stocks index weighted by the stock price. And a company with the highest dollar stock price affects the index the most. The S&P 500 is counted by a market capitalization. It accounts both for the stock price and the number of shares outstanding in the market.
Companies with a higher share price affect the Dow the most, while companies with the highest market cap affect the S&P 500 the most.
Has the Dow changed over time?
Industrial roots:
Back in time, when the Dow was created in 1896, it was fully industrial. It only had 12 members selected to reflect the big and bold American companies at the time. Among them were tobacco companies, leather, oil, animal feed, and rubber industries. The Dow has changed its membership 55 times within 125 years of its existence.
Now it’s becoming more inclusive:
The index has expanded to today’s 30 members. And its club has also changed to reflect the changing of the American economy. For example, a few years ago, the Bureau of Economic Analysis declared that manufacturing made up just 11% of the American economy. Therefore, the Dow had to adjust to the changing trends and become more inclusive to give a more holistic picture of the economy of the United States.
As of December 2022, the Dow includes companies from a variety of different industries.