The Dow Jones Industrial Average
You know it’s at 12311, down 116 points from today’s open. But what do these numbers even mean? What is this ‘Dow’ on which investors and the media fixate themselves? Is it really comprised of only 30 stocks?
Yes! It’s a market index, which is a listing of stocks which share some similar characteristic; they could belong to the same industry or they could all have similar market cap (how much a company is worth in $).
The Dow, the Nasdaq, and the S&P500 are the three main market indexes, providing the basic signal of how markets perform. The Dow is the most widely publicized and discussed, thus I’ll follow suit.
Some history.. The Dow Jones Industrial Average was started in 1882 by Charles Dow, the editor of the Wall Street Journal’s precursor, the Customer’s Afternoon Letter. Dow had a vision to create a benchmark that would project the general market conditions. Interesting to note that of the original 11 stocks of the DJIA, General Electric remains a part of the average. Today it is made of 30 of the largest and most widely traded blue chip companies in the US that are traded on the NYSE, as selected by the editors of the Journal. The composition of the Dow changes fairly often, in fact here’s a list of the deletions and additions over the past 30 years.
12311. So what?.. Even though it’s called the Dow Jones Industrial AVERAGE, they don’t simply add up the stock prices of the 30 companies and divide by 30. No, the average is price-weighted, meaning each stock influences the Dow in proportion to its share price. In order to account for stock splits (when a company’s existing shares are divided into multiple shares making, for instance, a $100 share worth 2 $50 shares, typically done to make shares seem more affordable when a company’s stock gets too high or higher than that of other companies in the same industry) and stock dividends (dividends made in stock pay out rather than cash), they concoct a Dow divisor by which the sum of the 30 companies prices is divided. That divisor is constantly changing depending on the stocks in the average, the splits and extra shares issued.
Can I buy the DJIA as if it were a stock?.. Well, not really. You can’t buy the DJIA as if it were a security, but you can buy a Diamonds ETF, which basically gives you a small ownership of the 30 stocks in the Dow. An ETF is an Exchange-Traded Fund which puts a bunch of pieces of stock into one overarching stock. You may be more familiar with the SPDR, Standard & Poor’s Depository Receipt, or Spider, which is an ETF for stocks in the S&P500. ETF’s hedge your risk - if one stock does poorly, you have others to back you up.
Problems.. While the Dow may be a good indicator of the macroeconomy, since the large scale companies on the index are global businesses, it may not be a great indicator for overall market behavior, especially for individual investors. Here are some problems with the Dow:
- There are only 30 stocks - not very indicative of the market.
- Companies with higher stock prices are given more weight, and those with lower stock prices are given less weight, regardless of the respective overall value of the company (as reflected in its market cap)
- The price-weighted index is that each dollar change in one of the stocks affects the Dow average by the same amount. It does not reflect the fact that a small increase in a lower priced stock is far more significant than that same increase for a higher priced stock. Many other indexes, like the S&P 500 are market-cap weighted, reflecting the change in the aggregate market value of all of the companies in the index. Most analysts agree that the S&P500 is a better indicator of the overall stock market than is the DJIA.
There are market indexes for just about every conceivable sector of the economy and stock market, ranging from commodity indexes, sector indexes like the MS Biotech Index, there’s even the 2008 Summer Games Index.