Your trading day would technically be incomplete without a mention of the Dow Jones Industrial Average in the news. And while you’ve often heard reports about the DJIA being down or up by a number of points, these movements won’t make much sense if you’re not at home with how this market index works. Luckily, this blog post provides an inside scoop of the Dow Jones Industrial Average.
What is the Dow Jones?
The DJIA, commonly referred to as “the Dow,” is arguably the most followed and widely-accepted stock market index. The DJIA is a price-weighted index that tracks the value of 30 publicly-traded companies listed on the New York Stock Exchange (NYSE) and NASDAQ.
Although the 30 companies are entirely in the United States, the Dow Jones index has become the microcosm of global financial markets — attracting scrutiny from across the globe. Most media commentators and investors view this index as a summary of the U.S. stock market performance.
When it was first launched in 1896, the Dow Jones index comprised only 12 U.S. companies that were largely engaged in industrial activities. Over the years, the index changed in tandem with the economy, and it’s now made up of companies in other sectors like retail, technology, and health. This index typically changes when one or more companies experience financial distress that deems it a less valuable company in its sector when there’s a huge shift in the economy that should be reflected in the index’s composition.
What Companies Qualify for the Dow Jones Industrial Average?
While there are no specific rules for a publicly-traded company to be included in the Dow Jones Industrial Average, the company must account for a huge portion of the economic activities in the United States. The company must also be listed on the NYSE or NASDAQ and be a leader in its sector.
Even so, the Dow Jones follows a systematic process when choosing companies that comprise the index. Although the underlying mechanism is sophisticated in nature, we can break down the most important points.
The Dow Jones Industrial Average uses a price weighting calculation, which implies that companies with higher share prices contribute a higher weighting to the index as compared to those with smaller prices. This means that while a company might have a smaller market capitalization, it may have a great weight to the overall average if its individual share price is higher.
The Dow Jones also makes sporadic adjustments to companies that constitute its weighting — underperforming companies are typically replaced with better performing ones. The most recent adjustment to the index took effect on August 31, 2020 to include these 30 component companies:
- American Express
- Cisco Systems
- Goldman Sachs Group
- Home Depot
- Honeywell International
- Intel Corporation
- Johnson & Johnson
- JPMorgan Chase
- Procter & Gamble
- The Travelers Companies
- UnitedHealth Group Inc
- Walgreens Boots Alliance
- Walt Disney
That said, if the U.S. economy is performing well, you can expect the Dow Jones index to follow suit.
Can I Trade the DJIA?
Since the Dow Jones Industrial Average is a measurable and not a purchasable investment vehicle, it’s impossible to trade it directly. However, you can invest in vehicles that track the index or its individual components.
For starters, you can invest in index funds linked to the Dow Jones Industrial Average or exchange-traded funds (ETFs) that track the Dow index. You’ll require a smaller initial capital commitment to invest in these funds but still enjoy a performance that mirrors that of the DJIA.
One of the most traded Dow Jones ETF is the SPDR Dow Jones Industrial Average ETF (DIA), which seeks to track the performance of the underlying index. Trading at about 1/100 of the DJIA price, your investment moves at an similar percentage, whether down or up.
Alternatively, you can trade the DJIA by investing in individual stocks listed on the Dow. By investing in the companies directly, you essentially get an ownership stake in the company. The number of shares you buy will determine how large or small your ownership stake is. Dow component stocks are particularly popular among investors since they comprise some of the largest companies in the U.S.
How Does the DJIA Differ from the S&P 500?
To the casual follower of the U.S. markets, the Dow Jones and S&P 500 might look similar. Both indices measure the U.S. stock market’s performance, comprise the largest companies, and are valued throughout the trading day. On the flip side, these two indices are entirely different, and here’s how.
Launch date: For starters, the Dow and the S&P 500 have different launch dates; the Dow was launched in 1896 while the S&P 500 was launched in 1957.
Number of companies included: The composition of both indices is also a major talking point. The Dow Jones is super exclusive — it’s like getting into the queen’s royal ball. The Dow Jones is now made up of 30 stocks, although it initially started with 12 stocks on the New York Stock Exchange. While this gives its 30 stocks some sense of prestige, it also weakens the Dow as an instrument of measuring the stock market in general. The S&P 500 is more inclusive — it comprises 500 companies, which represents the broadest measure of the U.S. economy.
How the companies are weighted: The values of both indices are also calculated differently. For instance, the index value of the S&P 500 is calculated by weighting every company according to the market capitalization, after which a divisor set by the S&P is applied to give the final value. On the other hand, the DJIA’s value is price weighted — the weighting of component companies is ranked by the share price, so higher-priced stocks have more bearing on its scale hence affect the index the most.
To wrap it up, stocks with a higher share price impact the Dow the most while companies with the largest market capitalization affect the S&P 500 the most.
Limitations of the Dow Jones Industrial Average
While it makes headlines in stock market coverage, the Dow Jones Industrial Average has its fair share of limitations.
Most evidently, the Dow only includes 30 stocks. With more than 5,300 stocks traded on the NASDAQ and NYSE, the Dow 30’s performance may not provide the best indicator of how the general market is performing. For that reason, the S&P 500 — which is more inclusive — is better equipped to answer the crucial question “what happened to the stock market today?”
Additionally, the price-weighting mechanism used by the Dow means that some of its components weigh in more on the index than others. For instance, as of this writing, Home Depot traded for about $273 per share while Walgreens traded for just $48 per share. This means that a move in Home Depot’s share price would have more than five times the effect of a similar move in Walgreens.
For these shortcomings, the broader S&P 500 index is largely accepted as a better indicator of the U.S. market performance. Besides, the S&P is weighted by market capitalization, which makes more sense to go by since it accounts for both the stock price and the number of shares outstanding.
The Dow Jones has undergone lots of adjustments since its launch, and this should continue as long as the economy evolves. While it isn’t positioned as the broadest measure of economic health and performance, it can be a good scoreboard when you need a helpful snapshot of what stocks are soaring.