The Dow Jones Industrial Average is an often-cited phrase in business and trade publications. Many new investors are unaware of its significance to trading securities.
Investing in shares of a corporation requires finely-tuned information and processes by which to value a firm and its future profitability. Equally important is the need for accurate measures of the health of a market to which the firm belongs. No other index of market conditions is more often cited than the Dow Jones Industrial Average (DJIA). The DJIA has enjoyed a long history and although it has garnered much criticism, it remains the most important stock market index.
A Brief History of the DJIA
Charles Dow, co-founder of Dow Jones and Company and one-time editor of the Wall Street Journal, created the DJIA to create a stock market index to indicate the general health of trading within the market. In terms of age, it is one of the oldest market indices second only to the Dow Jones Transportation Average, an index Charles Dow also created.
As its name implies, the DJIA is an average of some of the most widely publicly-traded companies in the U.S.. 30 companies comprise the average currently including such firms as Coca-Cola, Microsoft, Walmart, Disney. 3M, and Intel. The index did not always have 30 companies but the current DJIA is based on this number. Some of the history of the DJIA is implied by its name as many of the companies within the average are not heavy industrial companies as they were when the index was created. Disney for example is primarily in the entertainment and Microsoft in the software industries.
When first published in 1896 the DJIA averaged about 41. Since then, the index has fluctuated with the economic conditions of the time. A brief timeline of milestone closing averages looks like this:
1896 – 40
1906 – 100
1927 – 200
1928 – 300
1972 – 1000
1987 – 2000
1991 – 3000
1995 – 4000
1996 – 6000
1998 – 9000
1999 – 10000
2006 – 12000
2007 – 14000
How the DJIA is Calculated
The DJIA is a weighted average index which means the effects of such market changes as stock splits and adjustments to stock are not a factor in the index. This is done so that the index is comparable between time periods with a common set of conditions. Consequently, the average is scaled and does not reflect the actual average of the prices of the 30 companies. To compensate for stock splits and other adjustments, a Dow Jones Divisor is used so values of the average can be compared to other periods. The sum of all the prices of the 30 stocks is divided by this divisor. The formula for the DJIA looks like this:
DJIA = (Σp) / d
where p are the prices of the stocks and d is the Dow Jones Divisor. The symbol Σ indicates a summation or adding up of the p stock prices.
One criticism of the DJIA has to do with whether the trading of just 30 companies is really a representation of the market as a whole. With thousands of companies traded in the various stock markets, do 30 of the most widely-traded companies really indicate the health of whole markets? Also, since the DJIA is price-weighted, higher-price companies influence the average more than lower-priced companies.
In the stock markets, not all companies begin trading at the same time. Companies that start trading later than others are not included in the average until the first share of its stock is traded. Consequently, early averages reflect the trading of only a few companies and the closing price of the other companies from the previous day’s trading skewing the perception of the market. Other market indicators such as the S&P 500 or the Wilshire 5000 include many more stocks in their index providing a much larger sample size on which to judge the condition of the market.
Regardless of its criticisms, the DJIA remains as the standard by which to indicate market conditions for publicly-traded companies. Some of this stems from the tradition of using a standard that spans further into the past than any other general index. In addition, standards set early in any system die hard as investors and companies are unwilling to abandon even outdated or less-than-optimal indicators in favor of the familiar. Regardless, the DJIA is the most widely-recognized market index in the U.S. and is likely to remain so in the foreseeable future.