: Rafael Matsunaga via
Dow Jones Industrial Average
, commonly known as "the Dow," is a price-weighted stock index of
30 leading U.S. companies, roughly two-thirds of which are
manufacturers of industrial and consumer goods (see the full list
below). At its inception in 1896, the Dow Jones Industrial
Average contained strictly industrial companies, but S&P Dow
Jones Indices now says "the definition of industrial is kept
intentionally broad to provide an indicator that reflects the
performance of the entire U.S. economy."
Although its outdated design means it commands little
attention in the financial services industry, the Dow remains the
most widely quoted barometer of the U.S. stock market due to its
longevity and simplicity; as such, it has become arguably the
best known symbol of Wall Street on Main Street.
What is the history of the Dow?
On July 3, 1884, Charles H. Dow debuted a stock average of 11
stocks, nine of which were railroads (the other two were Pacific
Mail Steamship and
). This average, the ancestor of the Dow Jones Transportation
Average, was included in
Customers' Afternoon Letter
, a two-page financial daily that would become
Wall Street Journal
On May 26, 1896, Dow introduced a 12-stock industrial average
consisting exclusively of "smokestack" (industrial) companies.
The index value -- the sum of the prices of the stocks divided by
12 -- was then 40.94. Daily publication of the index began on
Oct. 7 of that yearin
Wall Street Journal
The index was expanded to 20 stocks in 1916 and then to 30
names in 1928. That year marked another important development, as
editors started to calculate the index using a divisor other than
the number of stocks in order to account for events such as stock
splits. You read that correctly: For more than three decades, the
Dow, a price-weighted index, made no adjustment for stock splits.
In other words, prior to 1928, if a company split its stock
2-for-1, it had the same impact on the index as if the shares had
suffered a 50% decline as a result of a dramatic sell-off.
How are Dow components selected?
The Dow is currently maintained by a committee that consists
of three representatives of S&P Dow Jones Indices and two
Wall Street Journal
. S&P Dow Jones Indices is a majority-owned subsidiary of
McGraw Hill Financial
; the other owners are the
and Dow Jones & Company (which publishes
The Wall Street Journal
According to S&P Dow Jones Indices, "while stock selection
is not governed by quantitative rules, a stock typically is added
only if the company has an excellent reputation, demonstrates
sustained growth and is of interest to a large number of
investors." The committee selects from a universe made up of "all
U.S.-listed stocks of companies that produce non-transportation
and non-utility goods and services," while seeking to maintain
"adequate sector representation" within the index.
Naturally, S&P Dow Jones Indices seeks a high degree of
continuity in the Dow and, with just 30 stocks in the index, the
company is very conservative when it comes to making any changes.
Dow Jones Indexes, a predecessor of S&P Dow Jones Indices,
cited a rule of thumb that changes are to be avoided unless they
are "compelling or unavoidable." In the most recent "refresh" of
the Dow last September,
Bank of America
. These changes all fall into the "compelling" category;
presumably the committee believes these companies are a better
reflection of the U.S. economy.
The following table displays the current Dow components,
broken down by sector:
Procter & Gamble
, Goldman Sachs,
Johnson & Johnson
Source: S& Dow Jones Indices.
General Electric is the only current component that was part
of the original 1896 index. Oddly enough for a "blue-chip" index
that purports to reflect the U.S. economy, the Dow doesn't
include two of the market's most prominent blue-chip companies:
most valuable U.S. company
and Warren Buffett's
What are the advantages of the Dow?
When it was first conceived, the Dow represented a great
advance, as it was the first attempt to create a benchmark for
the market's performance on a day-to-day basis. It remains
popular today due to its simplicity and long history (it's the
second-oldest stock market index in the world, behind the Dow
Jones Transportation Average).
However, the Dow Jones Industrial Average was a product of its
time, and as such, it's an outdated technology. Charles Dow
conceived it as an arithmetic average of 12 stock prices so that
it could be calculated with a paper and pencil. Although the
mechanics of the index calculation are a bit more complicated
today, the Dow remains a price-weighted index: The influence of
each company on the index is commensurate with the stock's price.
There's no theoretical justification for that choice, and given
the evolution of computational technology, there's no longer a
practical justification for it, either. As a result, financial
professionals mostly ignore the Dow.
Despite this, the Dow does a decent job of capturing the stock
market's performance. It's highly correlated with broader
indexes, such as the large-capitalization
Russell 3000 Index
, and the
Wilshire 5000 Total Market Index
But the question remains: Why would an investor follow the Dow
when there are multiple superior choices out there? The S&P
500, for example, is broader, weighted by market capitalization,
and nearly as ubiquitous. The same question applies to investors
who seek to replicate the Dow's performance (minus fees) with
products such as the
SPDR Dow Jones Industrial Average ETF
. If you wish to "own the market," there are much better
alternatives, starting with the
Vanguard Total Stock Market ETF
Dow: Investing Essentials
originally appeared on Fool.com.
Alex Dumortier, CFA
has no position in any stocks mentioned. The Motley Fool
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