If you watch the news, you’ve no doubt heard mention of the Dow Jones Industrial Average (DJIA) or “Dow” for short. What is the Dow? Simply put, it’s a number published daily by Dow Jones and Company — who publish The Wall Street Journal — that represents the average value of 30 large industrial stocks traded on the New York Stock Exchange.
The purpose of Dow is to gauge the stock market’s temperature, so to speak. If the economy is doing well, stock prices as a group tend to rise. If it’s doing poorly, prices as a group tend to fall. If a specific stock drops while the market as a whole is going up, that should reflect poorly on that particular stock; if a stock is rising faster or slower than the market as a whole, that tells you something as well.
With so many other stock indexes being published, such as the S&P 500, you might wonder why the DJIA is so often quoted in the news. The answer has to do with history and familiarity.
A Bit of History
Although today the Dow is comprised of 30 companies’ stock prices, when first published by Charles H. Dow in May 1896, it was made up of only 12 companies. Of those 12 companies, General Electric is the only company that remains on the list today. The Dow was expanded to 20 stocks in 1916 and then to 30 stocks in 1928, where it stands today. With such a long history it’s easy to see why the Dow is so often quoted.
If you were to add the stock prices of the 30 companies in today’s DJIA, you’d find that it doesn’t equal the DJIA published. This is because the Dow is calculated using the “divisor” method. Before the divisor method was introduced in 1928, the index was figured by adding the price of each stock and dividing by the number of stocks. However, problems began to arise when companies were added or removed from the list and when stock splits occurred. The divisor method can be a complicated one, but it is valuable because it allows for stock index value comparisons across time.
Despite including only 30 of the more than 3,000 stocks listed on the New York Stock Exchange, those 30 companies account for more than 25 percent of the market value of all stocks traded on the NYSE. And for those that need a more rounded summation of the stock market’s health, there’s the Dow Jones Transportation Average, which includes 20 different stocks of railroad, trucking, and airline companies; and the Dow Jones Utility Average, which includes 15 electric, gas, and other utility companies.
How Dow Stocks Are Picked
The editors of The Wall Street Journal select the stocks listed in the DJIA, in part, by taking a broad view of what “industrial” means. For Dow purposes, industrial means any company that isn’t a) a utility or b) in the transportation business. Remember, there are separate Dow Jones averages for those kinds of stocks.
In choosing a new company for the DJIA, they search for substantial industrial companies that possess both a history of successful growth and wide investor interest. Dow components rarely change, because the Dow isn’t a “hot stock” index. Moreover, the Journal editors believe that stability of composition enhances the trust many people have in the averages. The most frequent reason to change out a stock is a change in some crucial component of the company, such as a takeover. Whenever one stock is changed, the rest are reviewed.
Neither the DJIA nor any other index should be considered a prediction of where the stock market is headed. Rather, they are reflections of where the market has been. And as to how high it can climb: There are no mathematical limitations to the industrial average’s ascent. Also keep in mind that no matter how large the numbers, it’s the market’s trend at any given time that is important.