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What is the Dow Jones Industrial Average?

Elaine J. Hom, BusinessNewsDaily Contributor

The index shows how 30 companies have traded in the stock market.

The Dow Jones Industrial Average (DJIA) is a stock market index created by Wall street Journal editor Charles Dow. Founded on May 26, 1896, the average is named after Dow and statistician Edward Jones. The index itself shows how 30 large publicly owned U.S. companies have traded during a standard trading session in the stock market.

About 20 of the DJIA's 30 component companies are industrial and consumer goods manufacturers. The others represent industries including financial services, entertainment, and information technology. The DJIA is just one of Dow Jones' market indexes.

Dow Jones Industrial Average history

When the DJIA was first created, it was designed to gauge the well-being of the industrial sector with 12 stocks (which eventually increased to 30). These stocks included American Cotton Oil, American Sugar, American Tobacco, National Lead, and the Tennessee Coal, Iron, and Railroad Co., among others. While the DJIA first appeared on May 26, 1896, it did not appear in the Wall Street Journal regularly until October 7 of the same year. The starting point for the DJIA was 40.94, a far cry from the 13,000-plus point average in October 2012.

At the time, the stock market was not highly regarded and was not a popular form of investment. Bonds were the most widely accepted form of investment, as they were backed by real machinery, factories, and other tangible industrial assets. The average American was unable to discern whether or not the stock market was flourishing or perishing. Dow created this stock average to help people make sense of the stock market, comparing his average to placing sticks in the beach sand to determine if the tide was coming in or going out. Rising peaks and troughs meant a bull market, while dropping peaks and troughs indicated a bear market.

The DJIA, as well as the rest of the stock market, found itself grossly affected by politics and warfare. A number of global events triggered major changes in the DJIA, including:

  • The fear of WWI caused the suspension of trading for four and a half months, leading to a DJIA drop of nearly 25 percent on the day trading reopened.

  • In the great stock market crash of 1929 and subsequent Great Depression, the DJIA returned to its starting point, almost 90 percent below its peak.

  • The DJIA dropped 10 percent during the four-month period when Egypt seized the Suez Canal, triggering an invasion from Israel, England, and France.

  • The Black Monday crash of 1987 brought the DJIA down nearly 508 points, or 22.6 percent.

  • On September 11, 2001, the markets were closed after the terrorist attacks in New York and Washington D.C. When the markets reopened on September 17, the DJIA dropped nearly 685 points, or 7.13 percent.

How to join the DJIA

When choosing a company to represent an industry in the DJIA, the editors at the Wall Street Journal consider a number of factors. They select companies that represent and lead the market. How long has the company been around? How are shareholders treated? What kind of reputation does the company have in the industry? The Wall Street Journal editors are generally careful to pick companies that are relevant but not overly trendy. They are looking for staying power in the industry.

An example of the logic used to decide the DJIA companies is when DJIA component General Foods was bought out by Phillip Morris in 1985. Adding Phillip Morris to the DJIA doubled the number of tobacco companies (American Brands was already a component). As a result, the editors dropped American Brands and added McDonald's instead.

How the DJIA works

The DJIA is designed to provide a clear view of the current stock market, which in turn reflects the state of the U.S. economy. The index is calculated by adding the prices of the 30 stocks in the average and dividing by a divisor. The divisor has shrunk over the years to offset arbitrary events, like stock splits and roster changes at companies.

The average itself is price-weighted, which means that each company makes up a fraction of the index proportional to its price. With one common divisor, stocks with larger prices have more weight in the index than stocks with lower prices, thus earning the price-weighted index designation. While the Dow value is not the actual average of the prices of its component stocks, the formula generates a consistent value for the index. Because the DJIA is made up of large, frequently traded stocks, the price of the DJIA is based on many recent transactions, increasing market indication accuracy. For other indexes, less-frequently traded stocks can create a less accurate average.

The DJIA's uses and applications are numerous:

  • The DJIA monitors market conditions, enabling investors to identify overall trends and make smarter investment decisions.
  • The DJIA can indicate the future performance of stock holdings, mutual funds, and ETFs relative to the performance of the index.
  • Because the DJIA has been mapped historically for so long, investors can study correlations over time with multiple factors.
  • Rather than investing in companies individually, investment directly into the DJIA allows for a diversified portfolio.
  • The DJIA can be used as an effective benchmark to gauge other portfolios and individual investments. A strong portfolio would outperform the DJIA, for example.

Critics of the DJIA

There are a number of critics who believe that the inclusion of 30 stocks does not paint an accurate picture of the overall market. With close to 10,000 publicly traded companies in the United States, many believe that the DJIA does not provide a good sample size. Other critics point out that price-weighted indexes also don't consider percent changes in share prices, which many investors consider important. The DJIA also does not account for stock splits or stock dividends.

Whether or not this criticism is valid, the DJIA is still an influential stock market index that many consider to be the most useful market indicator in the United States.

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