How Does the Dow Jones Index Work?

by Mark Kennan

Whenever you watch a segment about how the markets performed for the day or the week, the Dow Jones Industrial Average, or DJIA, is almost always mentioned. Knowing how this market index works, as well as what it comprises, helps investors better understand the significance of changes in its value.

History

The DJIA was first calculated in 1896 by Dow Jones & Co. with the goal of simplifying the changes in the market into an easily understandable number. Originally, the Dow included nine railroad companies, a steamship company and a communications company. The average was calculated by adding the price of each of the 11 stocks and dividing the total to find the average price per stock. Dow then published this information in the Customer's Afternoon Letter, a predecessor of the Wall Street Journal.

Current Composition

The DJIA is made up of 30 different companies as of 2011. These companies are selected by the Averages Committee. The Committee does not have any hard-and-fast rules it must follow. Instead, it attempts to select stocks with superior reputations, prior sustained growth and that are of interest to many investors. In addition, the Committee attempts to maintain adequate representation of the different economic sectors in the index. Whenever one company is replaced in the DJIA, the Committee reviews the entire Index.

Accounting for Changes

One of the difficulties with continuing to calculate the DJIA over time is that stocks split and pay dividends and companies can merge or go out of business. To adjust for stock splits, the DJIA adjusts the divisor used to calculate the average. For example, if a stock does a 4-for-1 split, the divisor for that stock becomes four times smaller to keep the average the same. For dividends, the average treats the amount of the dividend as being reinvested in the company. Over time, companies may change their focus or go out of business. To keep the DJIA representative of the economy as a whole, the companies included in the index are reviewed on an as-needed basis and can be replaced with other companies. However, these changes are kept to a minimum for the sake of continuity.

Limitations

While the DJIA does attempt to select stocks that represent the overall economy, it is limited to just 30 companies. Also, these are larger companies with proven growth records, so it does not reflect how start-ups are performing. In addition, the DJIA is a price-weighted index, which means that a $1 increase in a company whose stock trades at $30 per share changes the index as much as a $1 increase in shares of a company whose stock trades at $500 per share, despite the increase in the smaller stock being much more significant.

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