Traders look to the Dow Jones Industrial Average to determine how the stock market is doing.

by S. Wade Hansen | Read/Post Comments | Share on Facebook

Every night on the evening news (or all day long if you tune into a cable business news channel like CNBC or Fox Business), you will hear commentators talking about the Dow Jones Industrial Average either by its full name or one of its shorter nicknames---the Dow Jones 30 or the Dow. Somehow as we are listening to the talking heads, we all seem to know that we are supposed to be happy when we hear that the Dow is rising and that we are supposed to be sad when we hear that the Dow is falling, but why? What on earth is the Dow Jones Industrial Average, and why should we care---or should we?

This three-part series will cover the following:

- What is the Dow Jones Industrial Average (Part 1)

- Why you should care about the Dow (Part 2)

- Why you shouldn't care about the Dow (Part 3)

Let's start by looking at what the Dow Jones Industrial Average is. Once you've got a good handle on what the index is, what it measures and how it's calculated, we will answer the question of whether or not the Dow is something you should care about as an individual investor.

What is the Dow Jones Industrial Average

The Dow Jones Industrial Average is a price-weighted index composed of 30 of the most widely traded large-cap stocks---which are supposed to represent the broader market as a whole. In theory, the movements of these 30 stocks should be representative of the overall market. Oftentimes, investors prefer to use indices when tracking the market to give them a narrower view of what is happening in the overall market. You have most likely also heard of some of the other major stock indexes like the S&P 500, the Russell 2000 and the Dow Jones Wilshire 5000 Composite Index. Each one of these indices provides unique information for investors.

The Dow Jones Industrial Average was originally created by Charles Dow in 1896---making it the oldest stock index still tracked today. At that time, the index only contained 12 stocks, and all of them represented large, industrial companies. The thought behind this index was that these large, industrial companies should be an excellent barometer for the U.S. economy because it was so closely tied to the growth of large industries.

The number of stocks comprised in the Dow has since grown to 30 as the market has evolved and diversified. And while many of the stocks within the Dow no longer represent industrial companies, the name "Industrial Average" remains.

The following stocks (and subsequent prices and market caps) were part of the Dow Jones 30 on August 19, 2008:

Calculating the Dow Jones Industrial Average

The Dow Jones Industrial Average was originally calculated as a simple average. All you had to do to determine the value of the index was add up the price of each of the stocks in the index and divide that sum by the number of stocks in the index. For instance, when the index was first calculated, Charles Dow added up the price of each of the stocks in the index for a sum of $491.28, divided that number by 12 and got the first ever reading of 40.94 for the Dow Jones Industrial Average ($491.28 ÷ 12 = 40.94).

While the basic concept is still the same, Dow Jones & Company---the company responsible for maintaining the index---has had to make some adjustments to compensate for the increased number of stocks in the index, for additions to and subtractions from the index (as companies emerge and decline) and for stock splits, spinoffs and other corporate actions. Today, instead of simply dividing the sum of the stock prices by a divisor equal to the number of stocks in the index (30), Dow Jones & Company uses a modified divisor of 0.122834016 [as of the time of this writing...click here for current divisor]. For instance, the sum of the stock prices listed above is $1,432.07. If you divide that number by the current divisor employed by Dow Jones & Company, you get a current value for the Dow of 11,658.58 ($1,432.07 ÷ 0.122834016 = 11,658.58).

For those of you hard core math folks, the formula for calculating a divisor change is as follows (see source):

Where:

- Divisor to be effective on trading session t+1
- Divisor on trading session t
- Components adjusted closing prices for stock dividends, splits, spin-offs and other corporate actions on trading session t
- Components closing prices on trading session t

What is Price Weighting?

As I mentioned earlier, the Dow Jones Industrial Average is a price-weighted index. A price-weighted index is an index where the stocks with the highest prices tend to have the largest impact on the value of the index. Looking at the list of 30 stocks above, you can see that International Business Machines Corp. (IBM) is currently the most expensive stock in the Dow, at $126.36, and that General Motors Corp. (GM) is currently the least expensive stock in the Dow, at $11.18. Now imagine that each stock moves up 10 percent. If IBM moves up 10 percent, it will at $12.64 to the numerator (the sum of all of the stock prices) in the equation above, while if GM moves up 10 percent, it will only add $1.12 to the numerator in the equation above. Even though each stock increases in value by 10 percent, IBM will have more than 10 times the impact on the value of the Dow.

Well, hopefully you have a good grasp on what the Dow Jones Industrial Average is at this point. Check out What is the Dow Jones Industrial Average and Should You Care - Part 2 and What is the Dow Jones Industrial Average and Should You Care - Part 3, where we discuss the situations in which you should care about the performance of the Dow and the situations in which you shouldn't care about it.

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