In discussions about the U.S. economy, you’ll likely hear a lot about the Dow Jones Industrial Average. But what is this important index, and what role does it play in measuring our economy’s overall health? Read ahead to learn everything you need to know.
What is the Dow Jones Industrial Average?
The Dow Jones Industrial Average (DJIA) is a stock market index created by Wall Street Journal editor Charles Dow. Founded on May 26, 1896, the average is named after Dow and statistician Edward Jones. The index shows how 30 large publicly owned U.S. companies have traded during a standard trading session in the stock market.
About 20 of the DJIA’s 30 component companies are industrial and consumer goods manufacturers. The others represent industries such as financial services, entertainment and information technology. The DJIA is just one of Dow Jones’ market indexes.
How the DJIA works
The DJIA is designed to provide a clear view of the current stock market, which, in turn, reflects the state of the U.S. economy. The index is calculated by adding the prices of the 30 stocks in the average and dividing by a divisor. The divisor has shrunk over the years to offset arbitrary events such as stock splits and roster changes at companies.
The average itself is price-weighted, which means that each company makes up a fraction of the index proportional to its price. With one common divisor, stocks with larger prices have more weight in the index than stocks with lower prices do, thus earning the price-weighted index designation.
While the Dow value is not the actual average of the prices of its component stocks, the formula generates a consistent value for the index. Because the DJIA is made up of large, frequently traded stocks, the price of the DJIA is based on many recent transactions, thereby increasing market indication accuracy. For other indexes, less frequently traded stocks can create a less-accurate average.
How is the DJIA used?
The DJIA’s uses and applications are numerous:
- The DJIA monitors market conditions, enabling investors to identify overall trends and make smarter decisions for the best return on investment.
- The DJIA can indicate the future performance of stock holdings, mutual funds and exchange-traded funds relative to the performance of the index.
- Because the DJIA has been mapped for so long, investors can study correlations with multiple factors over time.
- As opposed to investing in companies individually, investing directly into the DJIA allows for a diversified portfolio.
- The DJIA can be an effective benchmark for gauging other portfolios and individual investments. A strong portfolio would outperform the DJIA, for example.
The DJIA was created to give investors a broad view of the U.S. economy, with the 30 stocks representing different areas of the market.
DJIA history
The DJIA was initially designed to gauge the well-being of the industrial sector; it included 12 stocks, which eventually increased to 30. These stocks included American Cotton Oil; American Sugar; American Tobacco; National Lead; and the Tennessee Coal, Iron and Railroad Co.
Although the DJIA debuted on May 26, 1896, it did not appear in The Wall Street Journal regularly until Oct. 7 of the same year. The starting point for the DJIA was 40.94, a far cry from the five figures the index is at today.
Back when the DJIA was created, the stock market was not highly regarded or a popular form of investment. Bonds were the most widely accepted form of investment, as they were backed by real machinery, factories and other tangible assets. The average American was unable to discern whether the stock market was flourishing or perishing.
Dow created this stock average to help people make sense of the stock market. He compared his average to placing sticks in beach sand to determine whether the tide was coming in or going out. Peaks meant a bull market, while troughs indicated a bear market.
Did You Know?
When the DJIA launched, it consisted of only 12 companies in the railroad, cotton, sugar, gas, oil and tobacco industries. By 1928, the DJIA grew to include 30 companies, which is where it is today. NASDAQ, another index, is made up largely of tech companies.
The DJIA, as well as the rest of the stock market, has been affected dramatically by politics and warfare. A number of global events triggered major changes in the DJIA:
- The fear of World War I caused the suspension of trading for 4.5 months, leading to a DJIA drop of nearly 25 percent on the day trading reopened.
- In the great stock market crash of 1929 and subsequent Great Depression, the DJIA returned to its starting point, almost 90 percent below its peak. [Read related article: What Is a Recession?]
- The DJIA dropped 10 percent during the four-month period in 1956 when Egypt seized the Suez Canal, triggering an invasion from Israel, England and France.
- The Black Monday crash of 1987 brought the DJIA down nearly 508 points, or 22.6 percent.
- On Sept. 11, 2001, the markets were closed after the terrorist attacks in New York and Washington, D.C. When the markets reopened on Sept. 17, the DJIA dropped nearly 685 points, or 7.13 percent.
- The biggest drop in the DJIA occurred on March 9, 2020, with the index plunging close to 3,000 points as the COVID-19 pandemic hit U.S. shores. The Dow fell two more times in March. This series of drops was the worst three-point decline in the DJIA’s history.
FYI
The COVID-19 pandemic sent the Dow Jones Industrial Average plummeting nearly 3,000 points. But it has since recouped those losses and then some. The investors who stayed the course benefited the most. Just ask all those millionaire investors.
How companies are chosen to join the DJIA
When choosing a company to represent an industry in the DJIA, the editors at The Wall Street Journal consider a number of factors. They select companies that represent and lead the market. How long has the company been around? How are shareholders treated? What kind of reputation does the company have in the industry? The Wall Street Journal editors are careful to pick companies that are relevant but not overly trendy. They are looking for staying power in the industry.
An example of the logic used to decide the DJIA companies is when Philip Morris bought out DJIA component General Foods in 1985. The addition of Philip Morris to the DJIA doubled the number of tobacco companies represented, since American Brands was already a component. As a result, the editors replaced American Brands with McDonald’s.
Criticism of the DJIA
Many critics believe the inclusion of only 30 stocks does not paint an accurate picture of the overall market. With around 4,000 publicly traded companies in the U.S., many analysts believe the DJIA does not provide a good sample size. Other critics point out that price-weighted indexes don’t take into account percentage changes in share prices, which many investors consider important. Nor does the DJIA account for stock splits or stock dividends.
For the economic forecast, check the DJIA
Despite some criticism, the DJIA is an influential stock market index that many analysts consider the most useful market indicator in the U.S. It includes some of America’s oldest companies, as well as newer players that demonstrate a strong long-term outlook. Although the DJIA has evolved over the years, its purpose remains the same: to serve as a temperature check on the state of the economy.
Natalie Hamingson and Elaine J. Hom contributed to this article.
