The Dow Jones Industrial Average (.DJI) is the oldest and best known of the various stock market indices. While most people have heard of the Dow, as it's known, many don't know what it exactly represents.
The Dow Jones Industrial Average, also known by its acronym, the DJIA, is made up of 30 stocks that are "probably the most recognizable large companies that people would regard as being industrial in nature," says Sam Stovall, chief investment strategist at CFRA Research.
The DJIA is the market barometer most people turn to when people look to see the health of Wall Street. It was the index people heard about during the 1987 and 2008 stock market crashes. Currently, the Dow is sitting just under the record highs made in July.
Unlike other indices such as the S&P 500 (.SPX), which holds just over 500 stocks, or the Nasdaq 100 (.NQX), with over 100 names listed, the Dow sticks to exactly 30. Here are a few facts to know about the DJIA when it comes to investing:
A committee picks the 30 stocks
The Dow index started in 1896 by Wall Street Journal editor Charles Dow and Edward Jones. A few factors go into its makeup. A committee composed of three representatives of S&P Dow Jones Indices and two representatives of The Wall Street Journal decide on the stocks that are added or removed.
The averages committee, as it is called, doesn't use quantitative rules when the members select stocks. Instead, the committee adds a stock only if they believe the company has an excellent reputation, demonstrates sustained growth and is of interest to a large number of investors. The committee looks for U.S. companies incorporated, with most of its revenues generated domestically. Unlike other indices that may have scheduled rebalancing times, the committee makes it changes on an as-needed basis.
Timothy Chubb, chief investment officer at Girard, says with no definitive rebalancing times or defined metrics of how the average committee makes their decision, market participants can sometimes be thrown off when changes to the Dow occur.
"It's one of the things we kind of groan about when we hear a company is getting kicked out of the Dow," he says. "It's interesting because they can kick them out whenever they want, but the metrics and evaluation process of how they're picking the next company to replace a business is not something we know."
Similar returns to S&P
Even though the DJIA has only 30 blue-chip stocks, experts say the index matches the long term performance of indices with more stocks like the S&P 500. Since December 1974, the compounded growth rate for both the S&P 500 and the DJIA are a near match – at about 8.7%.
"It is interesting that here we have a list of 30 stocks that has been a pretty good representation of the stock market as a whole, especially when you compare it with an index that has 500 companies in it and [the S&P] represents anywhere from 70% to 75% of the total stock market value of U.S. stock market," Stovall says.
The DJIA specifically represents industrial companies, but the definition of industrials has changed since Charles Dow and Edward Jones' day. In the 1890s, industrials used to represent industries associated with the industrial revolution: manufacturing, construction and the fuels to drive those factories. That meant coal initially, then natural gas followed by petroleum. The companies that comprise the Dow today to reflect the business world, so there are a lot more technology companies such as Microsoft (MSFT), Cisco Systems (CSCO) and Apple (AAPL). Other companies include Nike (NKE), Unitedhealth Group (UNH), Coca-Cola (KO), Chevron (CVX) and United Technologies (UTX).
John Person, the founder of the educational advisory service PersonsPlanet.com, says the Dow represents various sectors of the market but focuses on large capitalization stocks. Technology and industrial sector stocks make up about 20% of the index, with consumer cyclical sector stocks at 17% and financial sector stocks at 15%.
What the DJIA doesn't include are utilities and transportation stocks – although Boeing (BA) is included, Person says. Instead, stocks in those sectors have their own indices, the Dow Jones Transportation Average (.DJT) and the Dow Jones Utility Average (.DJU).
Person says this price-weighted index holds many of the "blue blood" stocks and these companies have a slightly higher dividend. That boosts the index's overall dividend yield compared to the S&P 500 at 2.17% and 1.85%, respectively. While nonfinancial professional people see the Dow as a guide, Person says without including sectors like utilities and transportation, he thinks the Dow is limited in its use.
"It's not a true representation of the overall economy and the overall investment market," he says. "But it's the one that's most widely quoted over time. People associate the stock market going up when they hear in the news that the Dow is up."
Difference in weights
The Dow weights companies in its index differently than the other well-known indices, Stovall says. The Dow is price-weighted, so the higher a stock's price, the greater the effect a stock has on the Dow's index value. The S&P is a market capitalization weighted index, meaning it uses price times outstanding shares to create its index value.
To come up with the value, the index uses the Dow Divisor, which helps to keep the value accurate and to account for events like stock splits or spin-offs. The Wall Street Journal alters the divisor manually to keep it accurate. To get the DJIA value, all 30 stock prices are added up and divided by the sum of the divisor, which currently stands at 0.147. The price weighting can confuse some investors, Chubb says. "A common misunderstanding that we have with clients when we recommend a stock is that they'll look at a stock and say that stock's expensive," he says. "Price doesn't necessarily mean the size of a company."
Chubb gave the example of Boeing being the most expensive stock in the index, with a price of about $387 a share, compared to Apple, trading with a $222 stock price. Movements in Boeing's share price can have a greater influence on the Dow, even though Apple's market cap is several-fold greater.
It's impossible to trade an index but the closest investors can get to replicate owning the Dow is through an exchange traded fund called SPDR Dow Jones Industrial Average ETF, (DIA), which holds more than $21 billion in assets under management, with an expense ratio of 0.17%.
Chubb calls the Dow "a small slice" of the broader stock market and it provides a measure of how the titans of industry are performing, although with a limited focus. "Investors really should look at the S&P 500 or the Russell 1000 (.RUI) for a large cap benchmark because they're broader."
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