The Dow Jones Industrial Average is one of the most-watched stock index in the world - here's how it works and why it's so influential

Jim Probasco

Dec 15, 2020, 22:04 IST

The Dow Jones Industrial Average is one of the most-watched stock index in the world - here's how it works and why it's so influential

To many investors, the Dow Jones Industrial Average and its performance is synonymous with that of the stock market itself.hocus-focus/Getty Images

The Dow Jones Industrial Average (DJIA) is one of the world's oldest stock market indexes, consisting of 30 US corporate giants.
Despite some criticism, the Dow remains highly respected, a reliable gauge of the overall stock market and the US economy.
While you can't invest in the DJIA itself, you can buy an index fund that tracks it, or the individual stocks.

When people talk about "the Dow," "the Dow Jones," or "the Dow 30," they're referring to the Dow Jones Industrial Average (DJIA). And to understand the Dow, you must understand it's actually two things: a stock market index of 30 chosen companies and a benchmark number.

As an index, the DJIA one of the oldest and most widely recognized among the 3 million stock market indices in the world. As a constantly changing benchmark number, it's endlessly watched, analyzed, and bet upon. And in both capacities, the Dow acts as a stand-in for the US stock market itself - and a bellwether of the state of the US economy.

Understanding the Dow Jones

As the "Dow 30" moniker implies, the DJIA index consists of a select group of 30 blue-chip US companies publicly traded on the New York Stock Exchange (NYSE) and NASDAQ stock markets.

The collective prices of these 30 stocks make up the Dow average which is calculated every day by adding up the individual close of day prices of all Dow stocks, and dividing that sum by the Dow Divisor, a factor designed to compensate for stock splits and other variations in share prices.

The Dow Divisor is manually adjusted by The Wall Street Journal (owned by Dow Jones) to account for share buybacks, splits, payment of dividends, and other changes to Dow index companies' stocks.

The average and its movements are annotated in points, with each point representing a dollar.

The result of the calculation is the Dow Jones Industrial Average (DJIA) "close" for that day. For example, on Dec. 11, 2020, the Dow closed at 30,046.37, up 47.11 ($47.11) from the previous day, or +0.16%.

Like the shares within it, the Dow's constantly moving. As stock prices fluctuate, the DJIA goes higher or lower. This movement gives investors and traders a way to track the market based on the changing prices of those 30 stocks. The DJIA appears widely on financial and other news websites every day.

History of the Dow Jones

The DJIA was launched in May 1896 by Charles Dow and his business associate Edward Jones. Both were American journalists, co-founders of Dow-Jones and Company, then a financial news bureau. They thought it would help explain stock-market movements to readers.

It was the second stock market index ever created. The first was from the same team: the Dow Jones Transportation Average, born in 1884.

Originally, the Dow consisted of just a dozen companies in the gas, sugar, tobacco, railroad, and oil industries.

Over the years the index evolved, expanding to 30 companies and including every major industrial sector except transportation, utilities, and real estate.

The make-up of the DJIA has changed over the years too, with stocks being added or taken off. S&P Dow Jones Indices (a division of Dow Jones) and selected editors of The Wall Street Journal change the DJIA roster when they feel an update is warranted.

What stocks are in the Dow Jones?

As of 2020, these are the 30 companies whose stocks are currently represented in the Dow Jones Industrial Average index.

On average, a company is dropped and replaced by another only about once every two years. When they do it's because a company's importance or influence in its industry has fallen.

Most recently in August 2020, Exxon Mobil, the longest-tenured member of the Dow, was dropped and replaced by Salesforce, a cloud-based software company. Exxon joined the Dow in 1928 as Standard Oil of New Jersey and remained there, albeit with a couple of name changes, for 92 years.

The recent change, which resulted in a rare replacement of three DJIA companies, Raytheon, Pfizer, and Exxon with Amgen, Honeywell, and Salesforce, was precipitated by a 4-for-1 stock split by Apple. Apple's move shook up the DJIA's price-weighted index, causing the addition of two additional tech stocks.

Why the Dow Jones is important

Some of the Dow's power and influence is due to its sheer venerability as the second oldest stock market index. The fact it represents and reflects the market movements of such giants as Microsoft, Boeing, IBM, and Coca Cola is another reason for its significance.

It may not have as many stocks as some other indexes, but what it has is choice - a representative cross-section of corporate America's major players. And, as noted above, the roster does periodically change, representing the rise or fall of different sectors.

As a result, many investors see the Dow 30 as a gauge of the US economy, and the key industries influencing and driving it.

When a company is added to or dropped from the DJIA, the replacements often have repercussions in the market.

Criticisms of the Dow Jones

The DJIA is not without critics. Some economists point to the relatively small number of companies in the index versus those in other widely watched indexes, such as:

Standard & Poor 500 (500 large-cap stocks on several exchanges)
NASDAQ 100 (100 large-cap stocks on the NASDAQ)
the Russell 1000 (1000 large- and mid-cap stocks on the NYSE and NASDAQ)

For this reason, they argue the Dow can't be an accurate benchmark of US businesses overall. Given the small number of companies, each one can easily tend to overrepresent its sector.

Recall, for example, Apple's 4-for-1 stock split that upset the Dow applecart and forced the index to replace three companies at once to reset the balance.

Another major criticism involves the fact the DJIA is a price-weighted index, meaning the average is based just on the price of component company stocks. Other major indices, such as the S&P 500, are market-capitalization-weighted, a system that values a company by taking the current stock price and multiplying it by the number of outstanding shares.

The main advantage, at least in theory, to market-cap-weighting over price-weighting is that by calculating the overall market value of a company (total shares times price) versus single share price, the system should tend to behave more like the market itself.

How to invest in the Dow Jones

The Dow Jones Industrial Average, as an index, does not sell shares in itself.

Of course, you can always buy all 30 of its stocks individually, turning your portfolio into a mini-Dow.

But a more cost-effective way to invest in the DJIA is through an index fund that holds all 30 Dow stocks, mirroring the actual index.

One exchange-traded fund that does that: the SPDR Dow Jones Industrial Average ETF Trust (DIA).

This ETF puts 99.8% of its assets in all 30 Dow stocks, with the same weighting. It has no required minimum investment and has an expense ratio of 0.16%.

On the mutual fund side, Rydex Dow Jones Industrial Average Funds (RYDAX, RYDKX, RYDHX), invest more than 80% of assets in the Dow 30 with the rest split between derivatives and cash. All three funds require a minimum initial investment of $2,500, with sales fees starting at 1.70%.

Another quirky, but long-standing Dow value investing strategy is called Dogs of the Dow. The system is simple - buy the highest dividend-paying stocks in the Dow based on the idea that those stocks are undervalued. Since 2010 the Dogs of the Dow have posted an average annual return of 15.9%.

The financial takeaway

The Dow's unusual price-weighting (versus market-cap-weighting) system has weathered criticism almost from the index's inception in 1896. Still, despite this and its relatively small number of component stocks, the Dow Jones Industrial Average is one of the most-respected bedrock market indexes in the world.

Historically, DJIA's performance has tracked very close to the overall stock market's. So in the eyes of analysts and investors alike, as the Dow goes, so goes the nation - even the world - of stocks.