Why is the Dow Jones Important?

One of the most commonly reported and well-known financial indexes is The Dow Jones Industrial Average. Created over a hundred years ago, it is used by financial institutions to gauge the temperature of the stock market and by reporters analyzing the state of the US economy. In this article we will cover:

1. When was the Dow Jones Industrial Average created?
2. Which companies are included in the Dow?
3. How is the Dow Jones index value calculated?
4. What are the criticisms of the Dow?

When was the Dow Jones Industrial Average created?

Dow Jones and Company was founded in 1882 by Charles Dow, Edward Jones, and Charles Bergstresser - three prominent reporters of their day. Charles Dow was renowned for being able to report financial news, thought to be complex and impossible to understand, to the masses. Two years after co-founding Dow Jones and Company, Charles Dow created the first-ever market index which is now known as the Dow Jones Transportation Average. In 1896, Mr Dow wanted to create a tool for speculative investors to get a gauge stock market activity so he created the Dow Jones Industrial Average (DJIA). The original Dow consisted of 12 industrial companies that Charles Dow believed best represented the US economy. Those 12 companies were:

• American Cotton Oil Company
• American Sugar Refining Company
• American Tobacco Company
• Chicago Gas Company
• Distilling & Cattle Feeding Company
• General Electric
• Laclede Gas Company
• National Lead Company
• North American Company
• Tennessee Coal, Iron, and Railroad Company
• U.S. Leather Company
• U.S. Rubber Company

Of the original 12, General Electric was the last survivor that was replaced by Walgreens Boots Alliance in 2018. As the shape of the US economy has changed, so has the makeup of the Dow Jones Industrial Average to ensure the index maintains its purpose as an indicator of US economical health. In 1928, shortly before the Great Depression, the Dow was expanded to 30 companies to better represent the US economy and better serve its purpose as a bellwether for the US stock market.

Here are some historic milestones in the long history of The Dow Jones Industrial Average:

March 15, 1933: + 15.34% - The biggest one-day percentage gain in the Dow's history

October 19, 1987: - 22.61% - The largest one-day percentage loss is now known as Black Monday

March 29th, 1999: Dow breaks 10,000 points for the first time

January 25th, 2017: The DJIA closes above 20,000 for the first time

November 24th, 2020: The Dow Jones closes above 30,000 points for the first time

Which Companies are Included in The Dow?

As we've already mentioned, the component companies of The Dow Jones are intended to be a reflection of the US Economy. Therefore, the 30 companies that make up the Dow are regularly reevaluated to ensure all 30 are worthy of their place or if another company has grown in enough prominence to replace an incumbent. These days the index is governed by S&P Dow Jones Indices which is majority-owned by S&P Global. They have a selection committee that makes the decisions on which companies to include. Traditionally, the committee selects the biggest blue-chip companies (nationally recognized large market capitalization companies with a solid financial history) that are performing consistently in the market. The committee looks to replace companies that are becoming financially stressed, for example, AIG in 2008 (They suffered tremendously during the Great Recession). Otherwise, the committee may make changes to ensure the type of companies on the Dow fairly reflect the US economy.

Which companies currently make up the DJIA?

2020 has been the most dramatic in terms of changes to the Dow since the late 90s. The Dow Jones committee removed oil giant ExxonMobil, big pharma company Pfizer (though perhaps they'll be back in the index if the COVID-19 vaccine is successful), and Aerospace manufacturer Raytheon Technologies. Salesforce, Amgen, and Honeywell International were added to replace the three firms removed. These are the current companies used to calculate The Dow (which big names are missing?):

How is the Dow Jones Index Value Calculated?

When Charles Dow first conceived the index, he simply added the stock price of all twelve companies he chose for the index and then divided that figure by 12. This gave a simple average stock price of the 12 companies. This makes the Dow Jones Industrial Average a price-weighted index - the higher the price of a stock in the index, the greater weight (and therefore the impact of price movement) it has in the index. However, over time, a simple mean no longer truly represented the value of the index due to events such as a stock split (more shares are added with no change in market capitalization, leading to decreased stock price). To mitigate this issue, the Dow Divisor was born. The value of the index is calculated by summing the price of the constituent company stock prices and dividing by the divisor. The divisor is continuously adjusted to ensure corporate actions, like a stock split, are accounted for. The Divisor as of November 30th, 2020 stands at approximately 0.152 which means that it acts as a multiplier. For every dollar movement in a company, the Dow Jones value changes by about 6.58 points.

What are the criticisms of the Dow Jones?

The first major criticism of the Dow is the relatively few number of companies included in the Dow and the fact that they are all large-cap companies. Many argue that this means that the Dow Jones is not really a great indicator of the full US Economy which consists of many small and medium-sized companies. Building on this, critics argue that the selection criteria is not clearly defined and therefore major US companies are not included in the Index. One prime example of this is the exclusion of Amazon in the index. Amazon is one of the world's largest companies with a market cap of over $1 trillion and has a major influence on many other small and mid-sized companies.

The second major criticism is of the price-weighted index value methodology. Critics think that stock price alone is not a good enough reflection of a company's performance and that other factors, namely market capitalization, have to be included in any index calculation. For example, in the Dow, a company with a high stock price and low market capitalization could have greater weight than a larger company (by market capitalization) but a lower stock price. These critics would suggest that more diverse market capitalization indices, such as the S&P 500, are better reflections of the economy and more accurately reflect the value of each company in the index. Nevertheless, the Dow continues to be one of the most widely followed and well know indices in the financial world.

Rounding Up

The Dow Jones Industrial Average (Also known as The Dow, The Dow Jones, or by its stock symbol DJIA) is the second oldest stock index created in 1896. It now consists of 30 US large-cap blue-chip companies which change based on selections made by the Dow Jones committee. The value of the index is calculated by dividing the sum of the stock prices by a continuously updated divisor. Despite being criticized for lacking full representation of the US economy and unfair weighting of high stock price companies, it remains one of the most widely reported stock market indexes in the world.