The Dow is up, the Dow is down ... the daily news just wouldn't be complete without a report about the open and close of this market index. But although you've certainly heard reports about the Dow Jones Industrial Average (DJIA) being up or down a certain number of points, do you know what these points represent? Read on to find out how the Dow works and what changes mean for investors and the stock market.

The Dow and the Market

In the United States there are three major indicators, or indexes, of market movements: the Nasdaq Composite, Dow Jones Industrial Average (DJIA or "the Dow") and the Standard & Poor's 500. Collectively, these market indexes are referred to as the Security Market Indicator Series (SMIS). They provide a basic signal of how specific markets perform during the day. Of these three, the DJIA is the most widely publicized and discussed. Fortunately for us, it is also the easiest to calculate and explain.

History of the DJIA

Dow Jones & Co. was founded in 1882 by Charles Dow, Edward Jones and Charles Bergstresser. Despite popular belief, its original indexes were not published in The Wall Street Journal but in its precursor, called the Customer's Afternoon Letter. The first industrial  averages didn't even include any industrial stocks. The focus was on the growth stocks of the time, mainly transportation companies. This means that the first Dow Jones Index included nine railroad stocks, a steamship line and a communications company. This average eventually evolved into the Transportation Average. It wasn't until May 26, 1896, that Dow split transportation and industrials into two different averages, creating what we know now as the Dow Jones Industrial Average.

Charles Dow had the vision to create a benchmark that would project general market conditions and therefore help investors bewildered by fractional dollar changes. It was a revolutionary idea at the time, but its implementation was simple. The averages were, well, plain old averages. To calculate the first average, Dow added up the stock prices and divided by 11 – the number of stocks included in the index.

Today, the DJIA is a benchmark that tracks American stocks that are considered to be the leaders of the economy and are on the Nasdaq and NYSE. The DJIA covers 30 large-cap companies, which are subjectively picked by the editors of the The Wall Street Journal. Over the years, companies in the index have been changed to ensure the index stays current in its measure of the U.S. economy. In fact, of the initial companies included in the average, only General Electric remains as part of the modern-day average, though it may not be for much longer (see GE May Be Dropped From Dow: Deutsche Bank).

DJIA Complications

As you might have guessed, calculating the DJIA today isn't as simple as adding up the stocks and dividing by 30. Dow lived in times when stock splits and stock dividends weren't commonplace, so he didn't foresee how these corporate actions would affect the average.

For example, if a company trading at $100 implements a 2-for-1 split, the number of its shares doubles, and the price of each share becomes $50. This change in price brings down the average even though there is no fundamental change in the stock. To absorb the effects of price changes from splits, those calculating the DJIA developed the Dow divisor, a number adjusted to account for events like splits that is used as the divisor in the calculation of the average.

How Does the Dow Divisor Work?

To calculate the DJIA, the current prices of the 30 stocks that make up the index are added and then divided by the Dow divisor, which is constantly modified. To demonstrate how this use of the divisor works, we will create an index, the Investopedia Mock Average (IMA). The IMA is composed of 10 stocks, which total $1,000 when their stock prices are added together. The IMA quoted in the media is therefore 100 ($1,000 ÷ 10). Note that the divisor in our example is 10.

Now, let's say that one of the stocks in the IMA average trades at $100 but undergoes a 2-for-1 split, reducing its stock price to $50. If our divisor remains unchanged, the calculation for the average would give us 95 ($950 ÷ 10). This would not be accurate because the stock split merely changed the price, not the value of the company. To compensate for the effects of the split, we have to adjust the divisor downward to 9.5. This way, the index remains at 100 ($950 ÷ 9.5) and more accurately reflects the value of the stock in the average. If you are interested in finding the current Dow divisor, you can find it at the website of the Dow Jones Indexes and the Chicago Board of Trade.

And How Does the DJIA Number Translate into a Dollar Value?

To figure out how a change in any particular stock affects the index, divide the stock's price change by the current divisor. For example, if Walmart (WMT) is up $5, divide five by current divisor (0.14523396877348), which equals 34.42. Thus, if the DJIA was up 100 points on the day, Walmart was responsible for 34.42 points of the move.

Weighing the Index

The DJIA's methodology of calculating an index is known as the price-weighted method: Companies are ranked based on their share prices. On top of having to deal with stock splits, the downside to this method is that it does not reflect the fact that a $1 change for a $10 stock is much more significant (percentage wise) than a $1 change for a $100 stock. Because of price-weighting's associated problems, most other major indexes, such as the S&P 500, are market-capitalization weighted – that is, companies are ranked by the number of outstanding shares they have, multiplied by the value per share.

Downside of the Dow

That is only one drawback of the DJIA. Another reflects the fact that today the stock market is much more geographically dispersed and fragmented by company size and industry.  During the early 1900’s the Industrial Revolution spurred the creation of large industrial type companies, many of which were located in the U.S., that were representative of the overall economy.  But with the technological advances and advent of the world wide web, the proliferation of companies was multi-fold, and the creation of or the increase in the number of economically meaningful industries with companies located anywhere in the world, has shaped a market which is almost completely interconnected and interdependent. Because of the fragmented, global nature of today’s market, many feel the Dow is not an appropriate indicator of the overall economy.

The Dow and the Economy

The Dow serves three functions in today’s marketplace:

First the long history of the Dow serves as a reminder of and comparison for today’s market as compared to early markets.  Trend analysis is always important when trying to forecast the future and the longevity of the Dow serves this purpose better than all other indices.

Second while the Dow tracks only 30 large American companies, these companies are inclusive of all industries except utilities and transportation, creating a broad overview of the economy.  In general the stock market is a leading indicator and the trend of the Dow could be construed as representing the trend of the economy over the next year.  It may not have predictive power in ascertaining the level of economic activity but should be able to have directional predictability. 

Third, the Dow, garners an unmistakable and perhaps unwarranted amount of attention from the media.  Reporting on how the Dow fared on a particular day is pervasive and it is used as a proxy for the state of the economy.  So even though the Dow is not fully representative of a global, technology driven market, the psychological connection of it with the state of the economy is profound.

The Bottom Line

After 110 years as a marker of major market developments, the DJIA is still one of the most recognized and cited of all market indexes. While it may not represent the new market opportunities and early-stage fast growing companies, and may not be indicative of the overall economic strength of the U.S. economy given most of the companies in the Index procure a high percentage of revenue outside the U.S., it does provide some valuable purposes. So, despite all its shortcomings, the Dow is still one of the most-watched indicators for stock market performance and the shape of the U.S. economy.

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