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What is the Dow?

Jack and Nick Author Pic
Jack Kramer & Nick MartellAugust 26, 2019
Forbes 30 Under 30 in media, appeared on CBS, Cheddar. Registered representatives of Robinhood Financial LLC.
definition

Born in 1896, the Dow Jones Industrial Average (aka “the Dow”) is an index of 30 big and prestigious public companies — and it’s used to measure the stock market in general.

🤔 Understanding the Dow

Some stocks go up, some stocks go down. But how did “the market” do generally? Indexes group together a particular set of stocks so you can get a quick sense of the market’s movements. Created in 1896 by Charles Dow and Edward Jones, the Dow is made up of 30 large (aka “blue chip”) US companies, which are picked from time-to-time by a selection committee. The 30 tend to be big, profitable, and have long track records as publicly traded companies. The index is calculated using a weighted average of the 30 stock prices. When people say “markets were up” they often are referring to the Dow.

example

From October 2007 to March 2009, the Dow fell by 54%. The financial crisis and Great Recession caused stocks to fall, including companies tracked in the Dow index like McDonald’s in food, Merck in pharmaceuticals, and Microsoft in software (and those are just the “m’s”).

Takeaway

Getting selected to the Dow is an honor...

The Dow’s 30 companies are some of the most prestigious and well-known brands in the United States. Investors look to the Dow to learn how markets are doing in general. But since the Dow is price-weighted, it’s a less useful scoreboard than the S&P 500, which is value-weighted (by a company’s market capitalization). The Dow also only reflects 30 companies, so shouldn’t be used to assess the broader stock market. DOW 9

Tell me more...

Who’s in the Dow?
How is the Dow calculated?
How is the Dow different from the S&P 500?
How is the Dow different from the Nasdaq stock index?
How has the Dow changed over time?
Dow trivia

Who’s in the Dow?

If you’re a member of the Dow 30, you’re officially a “blue chip” stock. The “Industrial” part of the Dow’s full name was more descriptive of its past than its present. Today, the Dow’s 30 members include both industrial and non-industrial companies to cover a balanced mix of sectors.

Although there’s no official quantitative criteria for who is “blue chip” or who gets to join the Dow’s 30-member club, the selection committee looks for US-based companies with strong reputations and who’ve demonstrated sustained growth. They also must have their stock listed on the New York Stock Exchange or the Nasdaq. The selection committee makes changes to the index from time to time - most recently (as of May 2019), General Electric was removed from the index and was replaced by Walgreens.

As of June 2019, the 30 Dow companies are (listed below alphabetically):

How is the Dow calculated?

The Dow reflects movements in the stock prices of all 30 of its club-member components. Since it’s a price-weighted index, stocks with the highest price move the index the most. The index is then calculated by adding the stock prices of all 30 members and dividing that sum by a figure called the “Dow Divisor.” At one time, the Dow Divisor was a constant number. When the Dow was created in 1896, the calculation was very simple: add up the stock prices of the (at the time) 12 components, then divide by 12.

Today, it’s a bit more complicated. The Dow Divisor has become more complex, with tweaks to account for price-influencing corporate actions such as stock splits, spin-offs, or dividends. The Dow Divisor is determined by the administrator of the index (S&P Dow Jones Indices) to ensure the index remains consistent when corporate actions happen so it’s useful to compare over time. This way, the index rises and falls based on the underlying share prices of the 30 members, not the complex corporate actions like stock splits, stock dividends, or rights offerings. The Dow Divisor is adjusted when corporate actions or member changes happen to keep the index consistent. More on the calculation methodology can be found here.

The key to remember with the Dow is that companies with a higher share price move the market more.

For example: If Dow member #1’s stock rises from $100 to $110, and Dow member #2’s stock falls from $11 to $10, the Dow will increase overall, because stocks with bigger prices move the index more. Even though member #1 rose by 10% and member #2 fell by 10% in this example, it’s not a wash — the Dow rises.

How is the Dow different from the S&P 500?

Both the Dow (whose ticker symbol is DJIA) and the S&P 500 (ticker symbol SPX) are used as proxies to measure how the stock market is doing in general. But there are some key differences between the two:

  • Number of companies included: The Dow is super exclusive — it’s like getting knighted by the queen. While that brings a certain level of prestige to Dow members, it also weakens the Dow as a tool of measuring the stock market in general. What happens to stocks of the 30 largest companies isn’t necessarily the same as what happens to the stock market in general. The S&P 500’s name tells it all — it includes 500 companies. For that reason, it’s more inclusive, and is better equipped to answer the key question “what happened to the stock market today?”
  • How the stocks are weighted: The number you see for the Dow was about 25,000 as of May 2019. That number is calculated using the index method, and is based on the 30 stocks included in the index weighted by stock price. So the company with the highest dollar stock price has the most weight, and will therefore affect the index the most. The S&P 500, on the other hand, is weighted by market capitalization. Market capitalization makes more sense to weight by because market capitalization accounts for both stock price and number of shares outstanding in the market. The Dow’s weighting only accounts for one of those, and stock price alone isn’t the best measure of what matters in the stock 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.

  • S&P 500 = weighted by market capitalization = stock price and shares outstanding
  • Dow = weighted by stock price only

How is the Dow different from the Nasdaq stock index?

The Nasdaq Composite index (or “the Nasdaq”) is the 3rd big US stock index that tends to be mentioned at the top of US markets news (usually right beside the Dow and the S&P 500). The Nasdaq isn’t reflective of the broader US stock market, like the Dow tries to be. That’s because its membership is mostly tech companies. For that reason, the Nasdaq is a better measure of how tech stocks are performing, rather than the broader stock market (which the S&P 500 and to a lesser extent the Dow are better for).

For example: The Nasdaq rose from under 1,000 in 1995 to over 5,000 in 2000 as a result of the Dotcom bubble — investors bought up the stocks of tech companies during that period in an unsustainable way. When the bubble “burst” from 2001 through 2002, the Nasdaq fell almost back to 1,000.

During the same period the Dow also rose from 1995-2000 and fell during the years 2001 and 2002, but the rise and fall were not nearly as large as the Nasdaq, since the Dotcom bubble affected primarily stocks of tech companies.

How has the Dow changed over time?

Industrial beginnings

When the Dow was created in 1896, it was truly industrial. Its 12 members were selected to reflect the titans of American industry at the time, and included companies in the tobacco, lead, leather, rubber, animal feed, and oil industries.

Since then and through May of 2019, the Dow changed its membership 54 times.

Now it’s evolving to more diverse companies

Over time, the index expanded to today’s 30 members. And it also changed its makeup to reflect the changing of the American economy. According to the Bureau of Economic Analysis, manufacturing made up just 11% of the American economy in 2018. So for the Dow to better reflect the economy of the United States, it had to evolve away from purely industrial companies.

As of May 2019, the Dow included companies from a bunch of different business sectors. Here’s a chart, straight from the Dow’s factsheet:

DOW_desktop

Based on GICS sectors. The weightings for each sector of the index are rounded to the nearest tenth of a percent; therefore, the aggregate weights for the index may not equal 100%.

Dow trivia

It never hurts to have some friendly Dow trivia in your backpocket:

How the Dow Jones Industrial Average got its name: The Dow was founded by Charles Dow and Edward Jones in 1896. Dow and Jones already founded the Wall Street Journal in 1889

The longest-reigning member: General Electric was a member of the Dow since its inception in 1896 through 2018.

The largest single-day percentage gain: The Dow rose 11.1% on October 13, 2008 on news that European regulators would bail out certain financial institutions that were struggling from the financial crisis.

The largest single-day percentage loss: The Dow lost 22.6% on October 19, 1987 on what’s now known as “Black Monday.”

Disclosure: It is not possible to invest directly in a market index. Indices are not subject to any fees or expenses.

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