“How did the Dow do today?” is a popular question heard around the country at bars, social gatherings, and dinner tables. 30 years ago, investors would hear news about the Dow on their local radio stations or the nightly news. Today, investors can get their answers in real-time as they look at the crawl on any financial news station. They can even check the status of the Dow on their smartphone. When major world events happen, investors and non-investors alike feel a little more reassured when the Dow is up, and a little, or a lot, more anxious when the Dow is down but what exactly is it?
“The Dow” is shorthand for the Dow Jones Industrial Average (NYSEARCA: DIA) and despite being well into its second century; the Dow is still one of the most-watched stock market indices in the world.
But what is the Dow Jones Industrial Average? When was it created and why? What companies are part of the Dow and why and is the Dow still relevant for investors today? These and other questions are the focus of this article.
What is the Dow Jones Industrial Average (DJIA)?
The Dow Jones Industrial Average (DJIA) is an index of 30 blue-chip stocks that use a variable known as the "Dow Divider" to create a price-weighted average that fluctuates with price changes in the component stocks. The DJIA is intended to serve as a barometer for how the general economy is performing, and more specifically, how the stock market is performing.
The stocks selected for the DJIA are publicly traded stocks listed on either the New York Stock Exchange or the NASDAQ. No single metric is used for selecting the stocks that make up the DJIA. Rather the editors of the Wall Street Journal, who select the DJIA component stocks, use general guidelines that require them to select large, well-established, and respected companies that are responsible for significant economic activity in the United States.
Changes in the Dow reflect changes in the economy
The DJIA was created in 1896 by Charles Dow. Charles Dow was one of the founders of Dow Jones & Company, the same company that created The Wall Street Journal, and was in need of a way to track the value of the stock market. As you can imagine, the United States economy at the end of the 19thcentury was quite a bit different than it is today. The index of 12 stocks reflected that economy and consisted of just 10 railroad stocks and two industrial stocks.
However, just four years later, Charles realized that the industrial sector was beginning to have a much higher impact on the economy than railroads. So he created a separate index for the railroad stocks (which still exists today as the Dow Jones Transportation Average) and created a new list of 12 stocks that made up the DJIA. In 1916, the index added four additional stocks and in 1928 10 more were added to bring the index up to its current level of 30 stocks (called components).
Since those first adjustments (called reconstituting), changes to the DJIA have occurred relatively infrequently, but over time all the charter components of the Dow were replaced by other companies. In fact, the last original Dow stock, General Electric, was replaced in 2018 but one day it may come back. Today, some of the household names that are included in the DJIA include the Walt Disney Company (NYSE: DIS), The Coca-Cola Company (NYSE: KO),McDonald’s Corporation (NYSE: MCD), and Microsoft Corporation (NASDAQ: MSFT).
What does the DJIA measure?
At its inception, the DJIA was a simple arithmetic average. Charles Dow would literally total the closing stock prices for each of the 12 component stocks and divide that number by 12 (the number of stocks). The first published DJIA average was $40.94, which was simply the average of the twelve stocks that made up the index.
Today, a simple arithmetic average would not accurately reflect the value of the companies that make up the index. Stock splits and other transactions that companies use to modify their share price would make the Dow seem to be falling, even though the company is just as strong, and perhaps stronger than it was before the split.
For example, basic statistical analysis tells us that using a simple arithmetic average would mean that a stock that was trading for $80 would have more influence on the index than a stock trading at $20 per share. However, the stock that is selling for $20 per share could have a market cap that is significantly larger than the company trading at $80 per share, but a simple arithmetic average would not account for that difference.
Also, a company that issues a stock split is making what amounts to a cosmetic change to its stock price, but a simple arithmetic average would reflect this change by a drop in the DJIA.
To account for situations like this, the DJIA continually adjusts its divisor so that these events do not interfere with the historical continuity of the DJIA. One of the interesting things about the divisor is that after decades of adjustments it is actually less than one today (0.14748071991788). This means the divisor is really acting like a multiplier. That’s why the Dow can be listed at nearly 26,000 when the total of all the stock prices of the index is not nearly this high.
Is the DJIA an index fund?
The DJIA is not an index fund in and of itself. However, there is any number of index funds that use the DJIA as their benchmark. Some of the most popular index funds that track the DJIA are:
- SPDR Dow Jones Industrial Average ETF (DIA) - This fund, which was launched in 1988, tracks all 30 Dow stocks and uses the same weighting methodology as the DJIA.
- ProShares Ultra Dow30 (DDM) – This is a leveraged exchange-traded fund (ETF) with an objective of replicating two times the daily performance of the Dow. As a leveraged fund, the fund combines equity securities from the Dow along with derivatives to achieve its objectives.
- ProShares UltraPro Dow30 (UDOW) - This fund is similar to the Ultra Dow 30 with the exception being that its objective is to replicate three times the daily performance of the Dow. Like the Ultra Dow 30, this is a leveraged fund that does use derivatives to help them reach its investment goals.
- ELEMENTS Dogs of the Dow (DOD) – This ETF focuses on only the top paying dividend-paying stocks in the DJIA on an annual basis. The fund reconstitutes itself annually to ensure that it is including only the top dividend payers.
Criticisms of the DJIA
Like anything, the DJIA has its critics. Many economists and financial advisors discount the DJIA because they feel that an index, such as the S&P 500 which is adjusted for overall market capitalization, is more meaningful than the DJIA which ignores the size of the company that underpins the stock.
A related criticism of the DJIA is that by focusing on blue-chip industrial companies, it ignores other market capitalization categories that will be present in the average investor's portfolio. This is why the Dow can be up or down, but the individual investor might be experiencing exactly the opposite. These critics would say that if the DJIA is supposed to be a proxy for the broader market, how can it deliver on that promise if the components do not reflect the broader market?
A third criticism is that the components of the DJIA are selected by humans who introduce the possibility of human judgment which is never perfect. For example, if a component is removed from the index, experiences stellar growth, and then is reintroduced to the index, as was the case with IBM, the index would have no way of reflecting that company’s growth because the divisor is always adjusted to maintain continuity.
Yet another criticism of the DJIA is that by being limited to just 30 stocks, it lacks the overall diversification of other stock market indices.
Is the DJIA still relevant?
The short answer is if the DJIA is what it is and doesn't pretend to be anything else it is very relevant. Over time, it has proven to be a reliable, if not perfect, indicator of broad market activity.
However, one of the best ways to understand what the DJIA is means to understand what it is not. Let’s say the DJIA was to include the 30 “best” blue-chip components using any sort of common metric whether that be highest share price, highest market cap, largest trading volume, etc. While that would certainly represent an “all-star” collection of stocks, would it really serve the same purpose as the Dow?
The purpose of the Dow has never been to include the “30 best stocks” using a single metric or combination of metrics but to include 30 “of the best” blue-chip companies with the idea that when viewed in the aggregate, these companies will provide a more accurate snapshot of an investor’s experience.
Years ago, the United States put together a basketball team called “The Dream Team”. We assembled an Olympic basketball team that consisted of 12 of our finest professional basketball players. But a closer look indicates that this all-star collection of talent was more “dream” than “team”. For example, Hall of Fame forward Larry Bird of the Boston Celtics was the highest paid NBA player of the 1992 season. However, Bird, only a couple of years removed from the end of his career, was not a leader in any statistical category. By that measure, was he one of the 12 best players?
Magic Johnson came out of retirement to play on the Dream Team? Nobody would dispute Magic’s importance to the game, but was he one of the 12 best players at that time?
Christian Laettner was not yet a professional basketball player.
None of this is to say that these players did not merit inclusion on the team. Both Bird and Johnson were international faces of the NBA and certainly “reflective” of the best talent that the United States had to offer. But, if you were to try to apply a strict measurement for inclusion, several of them would not have made the cut, and several other players would have made the team. For example, if the highest salary was the metric then only four members of the team were even among the Top 10 in terms of salary in 1992.
The point with All-Star teams like the Dow is that they represent the essence of something bigger. There will always be “superstars” left out. The Dow looks at drivers of the overall economy and chooses components that reflect that in a broad way.
The bottom line on the DJIA
For over 120 years, the Dow Jones Industrial Average has been one of the most recognizable and widely followed stock indexes in the world.
The stability of the Dow is seen as a benefit or a liability depending on who you ask. While the methodology behind the DJIA can invite some reasonable criticism, investors still look to the Dow for general guidance, and companies included in the Dow find it a valuable distinction that they will work hard to maintain.