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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Dow Know-How: What Moves the World's Most-Watched Average?

When a person asks you, "How did the market do today?" it's safe to assume that he or she is looking for a quote on the most famous stock market metric in the world: the Dow Jones Industrial Average (DJIA).

However, it's also safe to assume that though everybody talks about the DJIA, almost no one understands what it actually is.

Often referred to simply as the Dow, the DJIA is used by many as a gauge for the health of the entire U.S. stock market.  But if you're interested in profiting from changes in the Dow or if you're interested in using it in your analysis, first you need to know what it is (and isn't), how it works, and how it can be used. Here's an overview.

Dow History

Financial reporter Charles Dow first reported the Dow Jones Industrial Average way back on May 26, 1896. "Jones" is Edward Jones, a name you're probably familiar with via his eponymous and successful investment firm. 

The DJIA was the first index to provide a quick gauge of the performance of the nation's largest companies. It started simply enough -- the prices of 12 stocks were added up and divided by 12, resulting in the first Dow Jones Industrial Average of 40.94.

It's interesting to note that of the Dow's original 12 components, only one – General Electric (NYSE: GE) -- has survived the numerous mergers, business failures and deletions from the index that have altered the composition of the Dow since 1896. The most recent deletions, made in mid-2009, replaced General Motors (NYSE: GM) and Citigroup (NYSE: C) with The Travelers Companies (NYSE: TRV) and Cisco (Nasdaq: CSCO).

The Dow Jones Industrial Average Today

Some of the largest and most well-known U.S. companies are components of the Dow. Editors from the Wall Street Journal hand pick firms that 1) have stock trading on American exchanges, and 2) produce non-transportation and non-utility goods and services. Transports and utilities have their own indexes.

The Dow is composed of just 30 stocks, making it one of the least diversified indices around. The companies are generally the leaders in their industry (blue-chips). If you're interested in seeing the component companies, click here.

The index is price-weighted, meaning that stocks with higher prices have a higher weighting. For example, on March 30, 2010, the stock with the highest weighting in the Dow was IBM, which closed at $128.77 that day. Conversely, the lowest weighted company was aluminum-giant Alcoa (NYSE: AA), which closed at $14.40. It is important to note that in a price-weighted index like the Dow, market capitalization is irrelevant.

The calculation behind the DJIA is somewhat complex, but essentially it's derived by adding up all 30 member stocks' prices and dividing that sum by a "magic number" called the Dow divisor. Today, the Dow divisor is 0.13232.

The Dow divisor changes fairly regularly to account for events like stock splits and replacement of companies within the index. When an event forces an adjustment in the divisor, the calculation is done so that the divisor is the same before and after the event. In this way, index continuity is maintained over time.

Dow Pros and Cons

The DJIA is probably the world's most widely recognized stock market measure. Its popularity makes it a quick andeasy reference when discussing how "the market” performed on any given trading day. Surprisingly, even though the index only contains 30 stocks it is highly correlated to more diverse indices like the S&P 500. 

#-ad_banner_2-#Still, because the average only contains 30 firms, some argue that it's outdated and does not truly represent the market as a whole. The sample is limited to 30 non-randomly selected, mature, blue-chip stocks, which is obviously not representative of the wider market. Many practitioners prefer to use the S&P 500 or the Wilshire 5000 as market benchmarks.

Furthermore, because the index is price-weighted as opposed to value-weighted (value-weighted indices are determined by changes in their components' market capitalization), price changes in some world's largest companies, including General Electric, Microsoft (Nasdaq: MSFT) and Pfizer (NYSE: PFE), actually have a lower impact on the Dow's performance than smaller members that happen to sport higher share prices.

Uses for the DJIA

As you can see, the Dow is more complex than just an average of 30 stock prices. But now that you understand the Dow and how it works, how can you put that knowledge to work in your portfolio?

Here are four ways that the DJIA and other indexes are used by investors and analysts:

1. Benchmark. The most common use of indexes like the Dow is as a benchmark. Whether you've entrusted your portfolio to a professional money manager or you're trying to manage it on your own, you need a frame of reference against which to measure success or failure.

The basic assumption is that any investor can easily track the performance of the market by investing passively in a broad market index fund or ETF. If you or your advisor can't do better without taking more risk, then you need to re-evaluate your strategy.

2. Index Portfolio. Speaking of passive vs. active investing, the second use for the Dow is as an automatic portfolio. There are several mutual funds and ETFs that track the performance of the DJIA, so if you want exposure to American, blue-chip, stable, mature companies and you're not interested in trading or stock-picking, you can easily put that part of your portfolio on autopilot.

3. Technical Indicator. Market technicians and other active traders often use historical DJIA performance to try to predict future price movements. A technician might start with charts showing the price and trading volume history of the Dow Jones Industrial Average as well as host of other statistical measures such as moving averages, maximums and minimums, and percentage changes.

The idea is to use the charts to identify trends and changes in those trends. Technical analysis is based on the belief that past market trends can predict the future behavior for the market as a whole and for individual stocks. If an investor can correctly interpret a chart's "message" and predict a stock's movement, he or she can obv a lot of money.

4. Risk Measure.  Finally, an index like the DJIA is often used as a proxy for systematic risk (also known as market risk or relevant risk). Systematic risk is price fluctuation caused by the "unknown unknowns" of everyday life, and it can only be avoided by avoiding all risky assets. The daily price changes in the Dow can be seen as the market adjusting for the constant fluctuations in systematic risk.

Systematic risk is one of the most important components of pricing models such as the Capital Asset Pricing Model (CAPM). As an analyst, you could use a formula like CAPM to decide what rate of return you should price in when deciding whether to buy a particular stock. If Stock A is riskier than Stock B, the price of Stock A should be lower to compensate investors for taking on the increased risk.

To learn more on the topics mentioned in this article, feel free to visit some of our additional content including a list of DJIA Component Companies, an introduction to Technical Analysis, and further explanation of the Capital Asset Pricing Model (CAPM).