The Tao of the Dow: All About Stock Market Indexes
What exactly is the Dow Jones Industrial Average, the mythic number that punctuates each day's stock market report? I've always wondered. Now, with the Dow crossing 12,000, I decided to roll up my sleeves and delve into what that 12,000 really means. Why should I care — and why should you?
When the Dow is at 12,000, that's not 12,000 dollars, obviously; nor does the Dow reflect the performance of 12,000 companies (the index only reflects 30 companies) — nor does the 12,000 have anything to do with the number of shares traded each day on the stock exchange (that's in the millions).
To wax philosophic, the Dow is at once larger than the sum of its parts — and less. To understand the Dow is to gain entry into a vital part of the investing world. In short, it's all about indexes. (Or indices, if you prefer.)
Let's step back in time for a quick dip into the history of the Dow, which dates back to the 1880s. If you're not a history buff, skip to the next section.
A short, geeky bit about the Dow's origins
In 1884, journalist Charles Dow compiled a list of eleven U.S. companies, and by averaging their stock prices came up with the Dow Jones Averages (with his colleague Edward Jones — not that Edward Jones).
In 1896, he revised the original list of companies, nine of which were railroads, to now comprise twelve companies that reflected the leading industries in America. You can read more detail here. It was a nifty idea: Select the top U.S. companies that reflected key industries, and average their stock prices each day as a gauge of how the market was performing overall. In other words, if six of the companies' stocks were trading at $30 per share, and the other six were trading at $40 per share, the Dow Jones Industrial Average for that day in 1896 would have been about 35.
Needless to say, the concept of having such an index to represent the market's value stuck. Messrs. Dow and Jones went on to create other indexes (as well as founding the Wall Street Journal, which you may have heard of).
Getting back to what the Dow is, and why we should care…
Today, the Dow is comprised of 30 large-cap companies — those with market capitalizations of $10 billion or more. As back in 1896, these companies are meant to reflect American industry (you can read the list here), but the Dow is no longer calculated strictly as an average, but a scaled average.
But what the heck is a scaled average?
Here's what the 12,000 means: the DIJA is calculated now by adding up the daily stock price of each of the 30 companies, and then dividing it by a fractional amount known as the divisor, which takes into account stock splits and other adjustments. Today the divisor is about 0.132129493.
The result is a somewhat arbitrary number — about 12,000 right now — that serves as a sort of barometer for the economy.
Why does the Dow loom so large?
On one hand, the Dow is still considered a bellwether for American commerce. But because the Dow is price-weighted — i.e., a company trading at $50 per share would make up five times more of the index than a company trading at $10 — that doesn't necessarily reflect companies' actual market values.
Plus, there are thousands of public companies in America, and you could argue that the performance of just 30 might not be the best gauge of the economy's health — and in fact people do make this argument, which is one reason the S&P 500 is seen as a better benchmark than the Dow.
But what's the S&P 500?
I'm glad you asked. The S&P 500 is Standard & Poor's index of the top 500 companies in America; it's another stock market index. And in case you can't smell where this is going, yes, there are now more indexes than there are sandwich possibilities in a deli.
So when you hear about index funds — a very popular investment product these days, especially among Get Rich Slowly readers — the next question you should ask is: “Which index is that fund tracking?”
There are many indexes that capture the performance of specific market sectors, whether it's small-cap companies or bonds foreign stocks or foreign small-cap bond stocks (kidding!). In this useful Money Magazine article, one expert quips that people are just creating indexes in order to sell new mutual funds that track those indexes. I wouldn't be surprised.
Certainly, if Mr. Dow were alive today he'd be shocked by how far and wide his original concept has spread.