Dow: Investing Essentials

Credit: Rafael Matsunaga via Flickr.

The Dow Jones Industrial Average, commonly known as "the Dow," is a price-weighted stock index of 30 leading U.S. companies, roughly two-thirds of which are manufacturers of industrial and consumer goods (see the full list below). At its inception in 1896, the Dow Jones Industrial Average contained strictly industrial companies, but S&P Dow Jones Indices now says "the definition of industrial is kept intentionally broad to provide an indicator that reflects the performance of the entire U.S. economy."

Although its outdated design means it commands little attention in the financial services industry, the Dow remains the most widely quoted barometer of the U.S. stock market due to its longevity and simplicity; as such, it has become arguably the best known symbol of Wall Street on Main Street.

What is the history of the Dow?

On July 3, 1884, Charles H. Dow debuted a stock average of 11 stocks, nine of which were railroads (the other two were Pacific Mail Steamship and Western Union). This average, the ancestor of the Dow Jones Transportation Average, was included in Customers' Afternoon Letter, a two-page financial daily that would become The Wall Street Journal.

On May 26, 1896, Dow introduced a 12-stock industrial average consisting exclusively of "smokestack" (industrial) companies. The index value -- the sum of the prices of the stocks divided by 12 -- was then 40.94. Daily publication of the index began on Oct. 7 of that year in The Wall Street Journal.

The index was expanded to 20 stocks in 1916 and then to 30 names in 1928. That year marked another important development, as Journal editors started to calculate the index using a divisor other than the number of stocks in order to account for events such as stock splits. You read that correctly: For more than three decades, the Dow, a price-weighted index, made no adjustment for stock splits. In other words, prior to 1928, if a company split its stock 2-for-1, it had the same impact on the index as if the shares had suffered a 50% decline as a result of a dramatic sell-off.

How are Dow components selected?

The Dow is currently maintained by a committee that consists of three representatives of S&P Dow Jones Indices and two representatives of The Wall Street Journal. S&P Dow Jones Indices is a majority-owned subsidiary of McGraw Hill Financial; the other owners are the CME Group and Dow Jones & Company (which publishes The Wall Street Journal).

According to S&P Dow Jones Indices, "while stock selection is not governed by quantitative rules, a stock typically is added only if the company has an excellent reputation, demonstrates sustained growth and is of interest to a large number of investors." The committee selects from a universe made up of "all U.S.-listed stocks of companies that produce non-transportation and non-utility goods and services," while seeking to maintain "adequate sector representation" within the index.

Naturally, S&P Dow Jones Indices seeks a high degree of continuity in the Dow and, with just 30 stocks in the index, the company is very conservative when it comes to making any changes. Dow Jones Indexes, a predecessor of S&P Dow Jones Indices, cited a rule of thumb that changes are to be avoided unless they are "compelling or unavoidable." In the most recent "refresh" of the Dow last September, Goldman Sachs replaced Bank of America, Visa replaced Hewlett-Packard, and Nike replaced Alcoa. These changes all fall into the "compelling" category; presumably the committee believes these companies are a better reflection of the U.S. economy.

The following table displays the current Dow components, broken down by sector:

Source: S& Dow Jones Indices.

General Electric is the only current component that was part of the original 1896 index. Oddly enough for a "blue-chip" index that purports to reflect the U.S. economy, the Dow doesn't include two of the market's most prominent blue-chip companies: most valuable U.S. company Apple and Warren Buffett's Berkshire Hathaway.

What are the advantages of the Dow?

When it was first conceived, the Dow represented a great advance, as it was the first attempt to create a benchmark for the market's performance on a day-to-day basis. It remains popular today due to its simplicity and long history (it's the second-oldest stock market index in the world, behind the Dow Jones Transportation Average).

However, the Dow Jones Industrial Average was a product of its time, and as such, it's an outdated technology. Charles Dow conceived it as an arithmetic average of 12 stock prices so that it could be calculated with a paper and pencil. Although the mechanics of the index calculation are a bit more complicated today, the Dow remains a price-weighted index: The influence of each company on the index is commensurate with the stock's price. There's no theoretical justification for that choice, and given the evolution of computational technology, there's no longer a practical justification for it, either. As a result, financial professionals mostly ignore the Dow.

Despite this, the Dow does a decent job of capturing the stock market's performance. It's highly correlated with broader indexes, such as the large-capitalization S&P 500, the Russell 3000 Index, and the Wilshire 5000 Total Market Index:

^DJI data by YCharts.

But the question remains: Why would an investor follow the Dow when there are multiple superior choices out there? The S&P 500, for example, is broader, weighted by market capitalization, and nearly as ubiquitous. The same question applies to investors who seek to replicate the Dow's performance (minus fees) with products such as the SPDR Dow Jones Industrial Average ETF (DIA 0.87%). If you wish to "own the market," there are much better alternatives, starting with the Vanguard Total Stock Market ETF (VTI 1.06%).