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.

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Tyler Karaszewski
Tyler Karaszewski
9 years ago

“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.”

Least-explanatory explanation ever. Might as well say, “we add up the stock price of all the included companies, apply magic, and there’s 12,000, which is your DJIA.”

Nicole
Nicole
9 years ago

Interesting. I feel smarter now.

Joe
Joe
9 years ago

More info on the divisor… but basically the “magic” is a number that they use to keep changes in the underlying stocks (eg. new company, split, etc.) from affecting the index overall. http://en.wikipedia.org/wiki/DJIA_divisor When a stock splits, the company says if you have x shares of our stock, you now have y. and the value of each share is adjusted to x/y. So a 2:1 (y:x) split cuts the price of the share in half. (more here: http://en.wikipedia.org/wiki/Stock_split ) To simplify it, lets say every single stock in the index splits 2:1, so the price of the shares is cut… Read more »

BB
BB
9 years ago

Here’s what I learned: DJIA goes up = good
DJIA goes down = bad

In other words, I echo the confusion above.
Where’d the divisor come from, for example?

sarah
sarah
9 years ago

Good primer. I always wondered where the number came from.

I’d also be interested to know more of the “yada yada yada” between adding up the prices and then dividing by the “divisor” but I assume the explanation is pretty tedious?

retirebyforty
retirebyforty
9 years ago

Good to know. Jeez, I’m a terrible investor, didn’t even know what 12,000 DJ average mean. Actually the “Average” should have alerted me that it was weighted.

Is the SP500 weighted too? I thought it just add up all the stock price.

Jaime
Jaime
9 years ago

Thanks Joe!

Barbara Friedberg
Barbara Friedberg
9 years ago

Although the DOW is a very popular metric, in reality it’s not very representative of the entire universe of stocks, since it is heavily weighted by co. size and only includes 30 companies. The S & P in general is a much more reliable index.

Psul Puckett
Psul Puckett
9 years ago

I think MP Dunleavey did a very good job in attempting to explain the Dow. The bottom line is that a thirty stock index is increasingly irrelevant to investors. There are many indices, and I agree a bit with the Rick Ferri quote in the linked article about unnecessary indices, but I would recommend investors consider the S&P 1500, or Russell 3000, or Wilshire 5000. All three include mid-cap and small-cap companies. You also should follow the MSCI EAFE for International and the MSCI EM for emerging markets. Performance measured against the S&P 500 only makes sense if all of… Read more »

Kristen
Kristen
9 years ago

I had an idea that the S&P 500 had to do with 500 companies… but had no clue that the Dow tracked so few.

I also am interested further in the ‘magic’ to get the divisor, but thank you for this article!

indio
indio
9 years ago

I enjoyed the rhyming in the post title. Merriam Webster has three definitions for Tao, but the first one is most relevant — 1a : the unconditional and unknowable source and guiding principle of all reality as conceived by Taoists. The “unknowable” part is applicable to that auto-magically selected divisor number. Sometimes it feels as if my 401k is overwhelmed by the “reality” of the stock market, especially when it takes repetitive market hits.

Doug
Doug
9 years ago

I work in finance. Let’s look at data from the CME from yesterday (the 23rd) to illustrate my point. The number of futures traded in the Dow (YM): 158,225 Wow, that’s a lot! Except that The number of futures traded in the S&P 500 (ES): 3,079,148. The volume in S&P 500 futures is ~ 20 times that of the Dow futures. Yet every time you turn on CNBC or what have you, the Dow is getting way more attention than the S&P 500. Why is this? I don’t know, but it’s pretty damn silly. Listen, the divisor for the Dow… Read more »

Chuck
Chuck
9 years ago

The S&P 500 is actually weighted by market cap–meaning the higher the value of the company, the more weight it gets in the index. Big companies like Exxon and GE count more toward the total value of the index. Basically it’s total value of the companies involved instead of a sum of the prices.

And again there is a divisor involved so that changes that don’t reflect changes in underlying company values don’t result in changes to the index’s value.

Another Dave
Another Dave
9 years ago

I like how people are concerned with the fact that the Dow has a “made-up/magical” factor to it… yet the very stocks (and the indexes that are based on them) are subject to arbitrary speculation and opinion. People seem to forget, with all this math, that a stock price is the “opinion” of the companies worth! An opinion by a mass mob of people who on a daily basis buy and sell the stock (either directly or thru funds).

Macke
Macke
9 years ago

The Dow industrial index is antiquated and only of historical interest, nothing more.

Most other stock indices are much better constructed and useful as a benchmark index, including the S&P 500. While S&P 500 does only capture about 75% of the stock market it is pretty much indistinguishable from a total stock market, so far.

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