Raise Your Investing IQ: Understanding the Ins and Outs of the Dow Jones Industrial Average

No doubt you’ve heard all about various stock markets and why it’s important to invest. If you’ve been reading around online, you may have heard about one such market index — The Dow Jones Industrial Average. But, you don’t really know much about it.

Here’s what the pros can teach you.

What Is It?

The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 stocks that are traded on the New York Stock Exchange (NYSE) and the NASDAQ. The DJIA was created by Charles Dow in 1896 and remains one of the most studied stock indices in the world.

It’s often referred to as “The Dow” and is one of the oldest, and most-watched indices. One of the reasons is because it includes big-name companies like General Electric, The Walt Disney Company, ExxonMobil, and Microsoft. Usually, when commentators say “the market is up” or “the market is down,” they are referring to the Dow.

History

It’s named after the index’s founder Charles Dow and his business partner, named Edward Jones. If that name sounds familiar it’s because Edward Jones is the name of a very large financial firm in the U.S. The Dow Jones Industrial Average was initially designed as a proxy for the broader U.S. economy. And, when it first launched, it included only 12 companies, most of which were industrial. At the time, industry drove the economy, so this was a largely accurate portrayal of how the economy was doing at any given moment in time.

The first components of the index were railroads, cotton, gas, sugar, tobacco, and oil. General Electric is the only Dow company that remained in the index since its beginning.

As the economy changes, and businesses change with it, the index changes. The Dow usually makes changes when a company experience a dramatic financial distress and becomes less representative of the economy as a whole. Usually, this also means that the country is shifting fundamentally one way or another to or away from that company and the products or services it sells.

For example, if Microsoft left the index, it would be because the company lost its financial strength and failed to represent the economy as a whole or because computer technology shifted in such a way so as to make the company obsolete. Normally, a company becoming irrelevant happens because it refuses to, or is unable to, change its core business to stay competitive.

How The Index Is Calculated

The Dow is a price-weighted index, meaning that stocks with higher share prices are given more “weight” in the index. When the Dow began, Charles Dow could calculate the average by adding the prices of the 12 Dow component stocks and then dividing by 12.

But, over time, this was insufficient. There have been additions, subtractions, and so on to the index, and mergers and acquisitions, along with stock splits all had to be factored into the accounting for the index. When one of these events happens, the divisor for the Dow is adjusted so the index’s value isn’t affected in a meaningful way.

This is why the Dow can stay at 17,000 while the sum total of the components’ stock prices are far below that.

Changes Over Time

The Dow has changed significantly over time. The index grew to 30 companies in 1928 and has changed its composition 51 times. The first change came within 3 months of the date the index was first launched. Its first few years were great, and then came the Great Depression. In 1931, 8 different stocks in the Dow were replaced. During this change, Coca-Cola Company and Procter & Gamble  Co. were added. These two stocks are still part of the Dow.

The most recent change was back in 1997 when 4 of the companies in the index were changed out. Two years later, 4 more were changed, and the most recent change was in 2015 when Apple Inc. replaced AT&T.

Conclusion
For investors looking to get a good idea of where the economy is going, the Dow is one of the best ways to figure it out. And, it also represents a great investment opportunity for those tracking the index for gains.

Whether you buy the index as a whole or individual companies within it, you are buying what many consider to be some of the strongest businesses in America.

Laura Hammond worked in the banking / financial industry for many years before taking a career break to have a baby. She enjoys writing informative, yet easy to understand, articles on finance topics.