Dow Jones Industrial Average: History, Calculation, and Critique

Introduction

The Dow Jones Industrial Average (DJIA) has been the most important source available concerning the direction and status of capital markets in the United States for more than a century (Hora & Jalbert, 2009). The DJIA is comprised of the leading publicly traded equity issues, which are reported in virtually all major newspapers and news reports in the U.S. as well as other industrialized nations (Hora & Jalbert, 2009). Despite this preeminent position in the financial industry, there remains a lack of understanding on the part of many consumers concerning how the DJIA is calculated or what the results of these calculations actually mean. To help fill this gap, this paper reviews the relevant literature to provide an overview and history of the DJIA, how it is calculated, and its constituent components. Finally, a critical evaluation of the DJIA compared to other financial indexes is followed by a summary of the research and important findings in the conclusion.

Overview and History of the Dow Jones Industrial Average

In May 1896, Charles Dow created what would become known as the Dow Jones Industrial Average by using the closing prices of a dozen of the leading stocks (Rosenberg, 1992). By January 2, 1897, Dow Jones was publishing averages for railroad stocks and using the recently invented telegraph ticker to broadcast financial news (Rosenberg, 1992). Because the index is based on the leading publicly traded equity issues in the United States (Hora & Jalbert, 2009), the constituent components of the DJIA have changed frequently since its inception more than 110 years ago. At present, the DJIA is comprised of 30 such publicly traded equity issues, ranging alphabetically from Apple, Inc. to Exxon Mobil Corporation (see Appendix A).

Based on his exhaustive analyses of financial cycles, Dow was able to formulate an indexing framework in which the DJIA became an important indicator of the financial health of the American business community. One biographer notes that "a longtime student of financial cycles, Dow made observations that led him to devise an ingenious barometer of the relationship between stock market trends and general business activity" (Rosenberg, 1992, p. 13). The eponymous theory developed by Dow was founded on the price activities of the constituent stocks comprising the DJIA, meaning that to the extent the industrial average reached unprecedented highs or lows, the so-called "rail average" — known as the "transport index" today — would follow suit (Rosenberg, 1992).

In addition, Dow believed that the performance trends of these constituent equity issues would serve as an indicator of the performance of the rest of the market (Rosenberg, 1992). According to Rosenberg, "Since these two averages represented two major areas of investment, it was Dow's belief that unless they both shifted in the same direction at the same time, the move could not be considered critical" (1992, p. 13). In sum, Dow maintained that relatively minor movements in either direction were merely transient or anomalous events that did not reflect the true status of the financial markets (Rosenberg, 1992). He also posited that if the industrial and rail averages both moved to unprecedented high levels, a bullish trend was taking place, and vice versa for a bear market (Rosenberg, 1992).

The industrial and transport indexes have both experienced significant changes over the years. These indexes no longer provide the same unrivaled indication of economic activity they once did, having been supplemented by newer and more sophisticated forecasting methods that use computer-based applications (Rosenberg, 1992). Notwithstanding these trends, the DJIA remains an important measure of directional movement in the financial markets and an oft-cited source among analysts (Rosenberg, 1992). Rosenberg concludes that "a number of financial experts still swear by 'the Dow,' and some investment-advisory services continue to view it as an important indicator" (1992, p. 14). It is noteworthy that Dow never expected this lofty status for his model; he believed the index was useful only as a framework for gaining a better understanding of market forces and activities. As Rosenberg (1992) points out, "Charles Dow never intended his theory to be used as the sole predictor of economic ups and downs. He saw it simply as a tool, an instrument that could be helpful in providing sound guidance to an investor's overall business and market strategy" (p. 14).

Despite this original intention, the DJIA has become a bellwether of the health of financial markets in the United States today. Some indication of this influence can be discerned from market activity in response to changes in the DJIA. For instance, Shiller (2000) argues that "a possibly significant factor behind the 1960s market peak was the Dow's approach to 1,000" (p. 110). In a case of the cart driving the horse, Shiller (2000) believes that heavy reliance on the DJIA served as a self-fulfilling catalyst for investors, despite Dow's original intent. Shiller concludes that "the approach of a new milestone such as a four-digit Dow would have an impact on the public imagination may seem silly, but . . . talk of such an arbitrary level provided a solid anchor for people's expectations" (p. 110).

Even the mainstream media embraced the unprecedented milestones being reached by the DJIA during the 1960s, a process that served to lend further credibility to the index. As the DJIA approached the seemingly magical one-thousand level, the editors of Newsweek reported that "the 900 barrier had reached almost mystical significance in the minds of many observers" (cited in Shiller, 2000, p. 111). By the late 1970s and 1980s, faith in the accuracy of the DJIA in forecasting market trends became firmly entrenched in American investment culture and in the minds of financial analysts (Forde, 1986). Haensly and Niranjan (2001) report that "the Dow Jones Industrial Average is the most widely followed stock market index in the United States. Many people intuitively use the DJIA as an indicator for performance in the broad market" (p. 102). Taken together, it is clear that the DJIA has become a vitally important financial index that continues to influence investors. Some observers, however, question its continuing relevance given that the DJIA is a price-weighted index relying on fewer than 30 stocks, compared to the more robust weighted measures provided by the S&P 500's index of 500 companies drawn from the more than 2,800 different company stocks that trade on the New York Stock Exchange (NYSE) today.

Conclusion

"Today, more assets are invested in products based on our indices than any other provider in the world. With over 1 million indices covering a wide range of asset classes and strategies across the globe, we continue to define the way investors measure and trade the markets." (Our company, 2016, para. 3)

Despite the merger, there are still fundamental differences between the DJIA and the S&P 500 that affect how each service reports financial news. The constituent components of the DJIA are selected by a panel from the Wall Street Journal, and their performance is evaluated using straightforward mathematical averages (Differences between DJIA and S&P 500, 2016). Stocks priced higher tend to affect the DJIA average more than lower-priced stocks (Differences between DJIA and S&P 500, 2016). By contrast, the 500 North American stocks used by the S&P 500 are selected by an S&P board and provide a wider range of representation across different industrial sectors (Differences between DJIA & S&P 500, 2016).

Moreover, rather than using simple mathematical averages as with the DJIA, the S&P 500 assigns weights to each stock depending on its current market value, and percentage changes are reported on the same index irrespective of stock price (Differences between DJIA & S&P 500, 2016). Simons (2015) identifies additional ways in which the DJIA and S&P 500 differ with respect to their ability to accurately report and predict market performance: "The largest difference between the two indexes is how they are selected for inclusion. The Dow's components are selected by a committee at S&P Dow Jones Indexes while the SPX's components roughly cleave to the largest 500 stocks with restrictions on trading volume" (p. 43). While the criteria for the selection of equity issues for the DJIA remain relatively opaque, the S&P 500 selection criteria are firmly established and publicized as follows:

1. Market capitalization of more than $5 billion
2. Four consecutive quarters of profit determined by net income less discontinued operations and extraordinary items
3. Adequate liquidity measured by price and volume (annual dollar value traded to market cap should be at least 0.3)
4. Public float of at least 50% (Differences between DJIA & S&P 500, 2016, para. 5)

These major differences have led some financial analysts to maintain that the DJIA is fundamentally flawed and should not be used as the primary indicator of market performance. Haensly and Niranjan (2001) cite four reasons why the DJIA fails to track market performance accurately:

1. A price-weighted index reflects changes in stock prices but not changes in market capitalization. In particular, each time a component stock splits, its weight in the DJIA decreases. A value-weighted (i.e., capitalization-weighted) index would overcome this potential weakness.
2. The DJIA may include too few stocks to adequately represent the U.S. stock market. Over 8,000 common stocks actively trade in the U.S. today, making the DJIA's sample potentially too small.
3. The editors of The Wall Street Journal follow an informal and subjective approach to select the Dow Jones Industrials, which may not yield the most representative sample.
4. Changes in the DJIA do not reflect the contribution that cash dividends make to total return (p. 103).

Given that Dow never intended for his index to be used in the fashion it is currently applied, these criticisms may seem misplaced. Nevertheless, the DJIA continues to play an important role in shaping investment thinking in the United States. A number of studies have confirmed that the DJIA has notable limitations when compared to other financial indices (Haensly & Niranjan, 2001). Haensly and Niranjan (2001) emphasize that "the DJIA exhibits significant and systematic tracking error as a measure of change in total wealth in the market. Specifically, the DJIA tends to understate change in total wealth, because the index does not reflect cash dividends paid by its component stocks" (p. 103). Consequently, it is not uncommon for the S&P 500 and the DJIA to reflect entirely different results after a day's trading, with one index indicating growth while the other reports a decline (Simons, 2015). Despite these differences and limitations, investors will likely continue to look to the DJIA first for information about the health of the economy, even if that information is based on an extremely small sampling of the broader market.

Created at the fin de siècle by Charles Dow, the DJIA represents the most frequently cited financial index used around the world to track North American stock performance today. The research is consistent in showing that the DJIA has been the source of numerous criticisms with respect to its ability to accurately model the performance of thousands of stocks based on the performance of just a few dozen, as well as the manner in which those stocks are selected. Despite these criticisms, the DJIA was never intended to be used in this fashion; it was rather intended as a tool to help investors gain a better understanding of the market. Regardless of its original purpose, the index continues to exert powerful influence over investment behavior and financial reporting worldwide.

Differences between the DJIA and S&P 500. (2016). Investopedia. Retrieved from http://www.investopedia.com/ask/answers/130.asp.

Forde, J. P. (1986, July 10). Market slide this week was just a 'correction.' (Dow Jones Industrial Average loses 80 points in 2 days). American Banker, 151, 3–5.

Haensly, P. J. & Niranjan, T. (2001, Summer–Autumn). Tracking error in the Dow Jones Industrial Average versus alternative market indices: New evidence. Quarterly Journal of Business and Economics, 101–104.

Hora, S. C. & Jalbert, T. J. (2009, September 1). The Dow Jones Industrial Average in the twentieth century — Implications for option pricing. Academy of Accounting and Financial Studies Journal, 10(3), 17–21.

Our company. (2016). S&P Dow Jones. Retrieved from

Pant, P. (2016, January 20). The S&P 500, NASDAQ, Dow Jones — what is this stuff? About Money. Retrieved from

Rosenberg, J. M. (1992). Inside the Wall Street Journal: The history and the power of Dow Jones & Company and America's most influential newspaper. New York: Macmillan Company.

Shiller, R. J. (2000). Irrational exuberance. Princeton, NJ: Princeton University Press.

Simons, H. L. (2015, December). Divergences: S&P 500 and the Dow. Modern Trader, 515, 42–45.

Apple Inc. | American Express Company | The Boeing Company | Caterpillar Inc. | Cisco Systems, Inc. | Chevron Corporation | E. I. du Pont de Nemours and Company | The Walt Disney Company | General Electric Company | The Goldman Sachs Group, Inc. | The Home Depot, Inc. | International Business Machines Corporation | Intel Corporation | Johnson & Johnson | JPMorgan Chase & Co. | The Coca-Cola Company | McDonald's Corp. | 3M Company | Merck & Co. Inc. | Microsoft Corporation | NIKE, Inc. | Pfizer Inc. | The Procter & Gamble Company | The Travelers Companies, Inc. | UnitedHealth Group Incorporated | United Technologies Corporation | Visa Inc. | Verizon Communications Inc. | Wal-Mart Stores Inc. | Exxon Mobil Corporation