The Dow Jones Industrial Average (DJIA) is an index of 30 of the largest publicly owned, U.S.-based companies and has been an economic force for over a century. It is also one of the most widely used indexes and plays a fundamental role in the stock market and the way people manage their income and investments.
Most investors use the DJIA to benchmark the performance of their holdings and they may even invest in the DJIA itself.
History of the Dow Jones
The Dow Jones Industrial Average was founded in 1882 and was one of several indices created by Charles Dow, Edward Jones, and Charles Bergstresser. Dow was an editor for the Wall Street Journal, Jones was a statistician, and Bergstresser was a journalist who came up with the name for the Wall Street Journal.
They created the DJIA in order to have a tool to assess the overall health of the industrial sector. Initially, the index was made up of a dozen industrial stocks, but over time, the focus of the index changed to incorporate other rising industries in the American economy. In fact, today, it contains very few industrial companies.
Stocks in the Dow
The Dow Jones is a price weighted index, which means that stocks with higher prices have more influence on the index’s value. It is made up of 30 stocks from a variety of sectors, including materials, consumer goods, financials, health care, industrials, oil and gas, technology, telecommunications, and utilities.
However, the index can be further categorized into sub-indexes to make it easier to track performance. These are based on whether companies are considered large cap, mid cap, or small cap; large cap stocks make up the majority of the index at 70%.
Companies within the DJIA change on a regular basis. In fact, none of the original 12 are still represented. The last company to be added was Cisco Systems in June 2009. Other than Cisco, only six companies have been added over the last ten years: Bank of America (2008), Chevron (2008), Kraft (2008), Pfizer (2004), Verizon (2004), and Travelers Insurance (2009).
General Motors was one of the longest-lived DJIA companies having been a constituent since 1907. However, its tenure ended when it was finally removed during the economic downturn in 2009. Editors of the Wall Street Journal are responsible for selecting and reviewing DJIA companies in order to give a broad view of the U.S. corporate environment.
How to Use the DJIA
The DJIA has several applications, including:
- Monitoring Market Conditions. The DJIA is perhaps the most widely used index for gauging the health of the stock market. Major indexes, such as the DJIA, provide at-a-glance knowledge of the stock market at large, so overall trends are easily identifiable.
- Performance Indicator. The DJIA can also indicate future performance of individual stock holdings, mutual funds, and ETFs relative to the performance of the DJIA. For example, by observing the beta coefficient, you can get an idea of how much a particular holding is likely to rise or fall in relation to the movement of the DJIA. If the DJIA is expected to increase by 10% and the beta coefficient of a given stock is 0.5, then it’s likely the return on that stock will be 5%. Of course, like any investment strategy or method, using the beta coefficient isn’t a foolproof way to forecast future returns.
- Historical Performance. The Dow Jones is one of the oldest indexes. Because it has been around so long, investors can track its performance over the years to study correlations over time with multiple factors, such as other indexes, significant cultural events, and even sunspots.
- Investment. If you want to diversify your holdings and your risk, you can buy this index instead of buying each of the 30 companies within it individually. By applying this strategy, you can purchase multiple positions without paying hefty transaction fees or mutual fund management fees and be invested in an array of the most influential and prominent U.S.-based companies.
- Benchmark. The DJIA can be an effective benchmark against which to gauge the performance of portfolios and individual investments. For example, if your portfolio consistently outperforms the DJIA, you can bet you are using a winning strategy. However, if a particular stock consistently underperforms the DJIA (especially in up and down markets), you may want to replace it with investments that at least track or even exceed the DJIA.
Criticism of the DJIA
Most celebrities can testify to the fact that you can’t please everyone. Over the years, the DJIA has acquired critics. Some of their most compelling arguments include the following:
- Smaller Representation. The DJIA represents a very small percentage of stocks in the entire stock market relative to many other indices. In fact, there are close to 10,000 publicly traded companies in the United States. However, the Dow Jones only tracks 30 of these. For this reason, many investors prefer indexes like the S&P 500 that measure a larger sample size.
- Proportional to Price, not Percentage. There is one key problem with price-weighted indices like the DJIA – they don’t consider percent changes in share prices, which is extremely important to many investors. For example, if there are two stocks trading within the DJIA at $100 and $10 and the price of the first stock increases by $1 while the other decreases by $1, the DJIA would remain unchanged. This would be the case even though the $100 stock had a measly 1% gain, while the $10 stock had a significant 10% loss.
- Not Adjusted for Stock Splits or Dividends. Because it’s a price weighted index, the DJIA does not adjust for stock splits or stock dividends. This means that the index will drop when a company declares either a split or a dividend, even though investors who hold the stock will not lose any value. When the DJIA is used as a benchmark for market performance, this type of effect can misrepresent what’s really going on.
Though much of the criticism is valid, the Dow Jones Industrial Average is an important and influential stock market index that won’t be going away anytime soon. Moreover, it has proven itself an effective benchmark, investment, and tool for investors for many years now.
In fact, it’s a hobby of mine to correlate planetary and seismic activity against market indexes, such as the DJIA. Believe me, the DJIA is a treasure trove of data for understanding the vagaries of investment behavior and the wide range of factors that influence it. But market correlations are just one of many uses for the DJIA.
How do you use the DJIA or other indexes for your investing activities?