What is the Dow Jones and how does it work?
IdeaEconomics YouTube video – Stocks 101: What is the Dow Jones?
I am excited to announce my new segment of articles that dive heavily into the stock world and answer questions you have always wanted to know! To kick it off, I tried to answer this question: what is the Dow Jones, and how does it work? So many of us constantly hear about the Dow on the news from other adults, co-workers, and social media platforms. People say that the Dow is up 100 points today, or you see these flashing pictures with many numbers in red or green. People at work may even talk to you about how the company’s stock was going up today and how excited that makes them.
Today, my goal is to break down the Dow and give you a back story as to how all of this came to be. I’ll explain how it works, including some pros & cons, and then ultimately why people care so much about the Dow. Welcome to my new segment, Stocks 101. Let’s get started!
What is the Dow Jones? The full title is called the Dow Jones Industrial Average. It was initially created by Charles Dow, Edward Jones, and Charles Bergstresser. The original goal was to compile a group of companies from the transportation industry and allow people to purchase those company stocks.
They founded the Dow in 1882, and as you can imagine, this took place during the industrial growth era. It resulted in the three gentlemen creating the Dow Jones Industrial Average and the Dow Jones Transportation Average. However, we will focus on the Dow Jones Industrial Average (DJIA) for this article.
The Dow is the main index most people look at when determining the health of America’s economy. Side note: an index indicates something to help raise public and private financial markets. A stock index would be a group of stocks that track a particular industry or segment in the economy.
Today, the Dow contains some of the top 30 companies in the country. Each company in the Dow falls under 9 out of the 11 sectors we consider in America. The nine sectors are finance, information technology, consumer staples, materials, industrial, communication services, healthcare, consumer discretionary, and energy. You will not find utilities in this index, and transportation companies generally fall under the DJTA umbrella.
Below, you can see a chart with the current companies in the Dow and the ticker name each company goes by in the stock market. As there are a copious amount of company names, the initials of each company can allow people to identify the stock quicker when displayed on a screen.
If you are like me, you may be wondering why 30? That is such a specific number, and why does America rely on only 30 companies to determine the economy’s health? I was genuinely baffled that these 30 companies could act as a compass for our finances. After hours of researching, that bafflement and confusion turned into anger when I found no clear reasons why the Dow only has 30 companies. The only information discussed is that Charles Dow originally started the number at 12 and grew it to 30 before deciding that was the limit…
There is no set standard for when a company in this list can get dropped or when a new company can slide into the Dow’s DMs by knocking out a competitor. The best explanation the Internet can give us about when a company may be introduced or replaced in the Dow is because of The Wall Street Journal editors. Weird, right?
Charles Dow worked as an editor at the Wall Street Journal, and his business partner happened to be Edward Jones. Since then, it’s been a known thing that the editors from Wall Street Journal subjectively select a company they believe represents the “qualities” of the Dow Jones index.
You’ve probably heard of the 30 companies above called a different name, such as a blue-chip or large market cap when you think of the Dow. These two names are used interchangeably because a blue chip is a massive company with a national reputation that is highly respected. A large-cap is a company valued at over $10 billion. Usually, most companies that are considered blue-chip will also be large-cap companies.
It’s helpful to understand this because you’ve probably heard people talking about points with the Dow when you hear these terms. Things like, oh ****. My stock just went down 78 points, or heck yeah, baby, my stock just soared 200 points today! What do points even mean? To be more specific, for every $1 price change in a company’s stock, that is the average of about 6.78 points. So if a company’s stock went up by 10 points, you would equate that to the company’s stock per share price increasing.
Let me give you an example. Let’s say that you were grabbing a caramel macchiato at Starbucks and overhear a conversation of someone telling their friend that the Dow just went up by 200 points! They tell their friend how they have the American Express stock. They want to understand how much of those 200 points were because of the American Express stock increasing that day. What they would do is look at the current price of the stock. We will say each American Express stock price per share is $10. You would take that $10 stock per share price and divide it by the current Dow divisor set at .152 (you can Google current Dow divisor 2021 to find this number).
10/.152 = 65.79
65.79 means that out of the 200 points of growth for that day, American Express contributed 65.79 points to the total 200. Around 1/3 of the stock growth for the Dow index came from American Express.
If you click the link above, you can see the red and green numbers/arrows connected to each company. Anytime you see numbers in red, the company is performing worse than it did yesterday. At the same time, the green numbers indicate that the company is performing better than it did yesterday. People in finance or investments will be paying attention to these numbers and colors because they can explain how the stock is performing during a 48 hour-ish window.
Now that we have discussed the nuts and bolts of the Dow, let’s discuss the pros and cons of this index.
PROS
- Historical Patterns. The Dow Jones Index has existed since the late 1800s and has been in the stock world for more than 125 years! So much data can be tracked to help forecast future disasters and spikes on the stock market. Many patterns can be diagnosed just from reading the past trends and making educated assumptions about what will happen next. Many stockbrokers will talk your ear off about how they can predict future stocks just by analyzing the Dow. More importantly, America’s economy relies on using the Dow as a benchmark to understand our financial health.
- Stability. Its longevity in the stock market is highly valued, which says a lot because the stock market can be so fickle. It reassures people that this index has been around for over a hundred years and is necessary for our government. Its big selling point is that it has 30 large, blue-chip companies that are probably not going out of business anytime soon. So if you do decide to invest in any of the 30 companies, you’ll probably be safe.
CONS
- Price-weighted. Compared to the other famous indexes like the NASDAQ or S&P 500, the Dow is measured by a price-weighted system. If one company in this group has a high stock price, it will have a more significant influencer over the whole group. A price-weighted index like the Dow will add up all the stocks per share and divide it by the total number of companies. This can be dangerous if the company has a major disaster because its CFO decided it was okay to embezzle. The company’s stock could massively tank after it gets out to the public what the CFO had done. The CFO’s action could negatively impact the company’s stock and the Dow index. If that happens, it can cause other companies to see adverse ripple effects, which can trickle down to affect even more people. The Dow being price-weighted is a heavily discussed topic. Many finance professionals want the Dow to be capitalization-weighted (another term is market-cap-weighted). That means that companies with higher market values will hold more weight than companies with smaller market values.
- Tech Industry Era. The times of the 1800s have long passed us. We are now living in a generation that is being ruled by technology. Mogul tech companies like Amazon, Facebook, Google, and Tesla, to name a few, are considered the future pioneers of the 21st century. The concern with the Dow is that it does not represent the giant tech companies that are dominating the world. In addition, to the other companies who have a value of $10+ billion. Many argue that the Dow is not an accurate representation of how the economy performs.
- No Direct Investing. Unfortunately, you cannot invest directly into the Dow Jones index. It is impossible to invest in the Dow because it is not a physical company that can instantly offer you stock. Instead, if you wish to invest in the Dow, you must think outside the box. You could buy the individual stocks of each company, so you’d own the stocks of 30 separate companies. A more common option is to work with a broker and purchase stock through an exchange-traded fund (ETF such as the SPDR Dow Jones Industrial Average) or mutual funds that mimic the Dow. I discuss in another article what ETFs and mutual funds are. A third option is to invest in the Dow through options and futures. Please keep in mind that these methods are generally reserved for people familiar with these methods.
After all that, the question remains: why does the Dow matter, and why should we give a rat’s butt? Do you know that saying you can’t teach an old dog new tricks? The government and the Dow are kind of like that old dog.
The Dow has such a long history compared to other index funds that it is still regularly used to forecast the future events of the economy. Unfortunately, because the Dow is over a century old, the government and the financial sector have become too reliant on this index. Also, the media is a powerful entity that sways a lot of the population. The news articles, social media platforms, and television programs spread information on how important the Dow is.
Well, you can understand how it might take some time before we rely entirely on other methods when looking at the health of our economy. However, the tide is slowly shifting away from this. We are starting to rely more on index funds based on their values, in addition to forecasters looking at companies that are currently trending and influencing our economy as a whole.
As people in the Millennial and Gen Z groups become more powerful in the workforce, many old ways will be abandoned. While new methods are being discovered, they can help improve our economy and provide us with more accuracy over time. Of course, this is my optimism speaking. I have always liked to view the glass as half full, especially life.
This concludes the first article in my Stocks 101 segment, and I hope that it was helpful to you and got you thinking more about the stock market! I always want to hear your thoughts and questions, especially about the stock market. Please email me your questions and leave comments below because I want to know what you think. Check out the website to keep reading more!
And remember, like Earl Nightingale said, “Everything begins with an idea.” See you again next time!