Any investors listening to the morning radio or turning on the television during the week will hear about the performance of the Dow Jones Industrial Average. The investing media pundits seem to go into a wild panic whenever it falls and rejoice whenever it rises. A popular question, though, is why?
The Origins of the Dow
To understand what the Dow Jones Industrial Average (DJIA), which is known to many simply as “the Dow”, means, first, you have to know what it meant back when it began. The precursor to the Dow Jones Industrial Average started in 1896, and its purpose was to provide a measure of how the industrial economy was performing. To do that, it started with 12 companies.
The original companies
The American Cotton Oil Trust, which dominated the cotton oil industry, is now part of Unilever. American Sugar was the main producer of sugar for the United States, with plantations in Puerto Rico and other Caribbean nations. Ultimately American Sugar was bought by Domino Sugar. American Tobacco was broken up by the SEC into multiple companies. Chicago Gas, which has now become Integrys.
Distilling and Cattle Feeding, oddly enough, produced whisky and had nothing to do with feeding cattle. General Electric still exists today but was removed from the Dow in 2018. Laclede Gas was and still is a natural gas company in Missouri. The North American Company was a holding company with interests practically everywhere. National Lead was the biggest company in the lead-smelting industry. Tennessee Coal, Iron, and Railroad was a major mining and transport company. U.S. Leather was dissolved after antitrust lawsuits, and U.S. Rubber jumped from owner to owner until it was bought by Michelin in 1990.
These dozen companies spanned nearly the entire industrial sector of the United States. And that was the goal, to ultimately sum up the industry of the United States with an average. As companies fell apart and new companies rose through the ranks, the Dow added and removed companies. In fact, none of the original 12 companies are on the current Dow, which is now comprised of 30 companies.
The Wall Street Journal
A more modern incarnation of the DJIA was first published in the Wall Street Journal in 1916. That index included 20 stocks – eight from the old index and 12 new stocks. In 1928, the index expanded to 30 stocks.
Today, the Dow isn’t necessarily the most important measure of the stock market and the economy. With the rise of more indices, both broader and more specific, there are more ways to quantify the performance of the stock market and, more importantly, your own portfolio. The S&P 500 is an index of 500 stocks spread across the nation in various industries. There are also countless indices for specific sectors of the economy.
Does the Dow Do a Decent Job of Diversifying?
Throughout the entire economy of the United States, it is very difficult to create a thorough and complete picture of the economy with only 30 stocks. If your portfolio was heavily based in the automotive and oil industries, then the Dow wouldn’t really reflect your portfolio. The Dow does not currently include any stocks in the automotive or oil industries. Similarly, if your portfolio is based in companies outside of the United States, the Dow couldn’t represent your portfolio. All of the stocks in the Dow are based in the United States. That being said, almost all of the companies represented in the DJIA do have a worldwide business and could be affected by political factors.
Ultimately, it is important to realize that the Dow, in most cases, doesn’t represent your portfolio. If you wake up one morning and see that the Dow has dropped 8%, your portfolio won’t match that exactly unless you are solely invested in a Dow Jones Industrial Average Fund. Because the Dow only represents 30 companies, the change in the price of one stock can drastically change the value of the entire average. While in indices like the S&P 500, it would take a much larger change in one stock to sway the entire average.
Also worth noting, the Dow is what is called a price-weighted index. This means that the stocks with a higher trading price are weighted more heavily than the stocks with a low trading price. For example, Caterpillar (CAT) is currently trading at around $287.57, while Walt Disney Co (DIS) is currently trading at around $86.30. Even though the market capitalization of Disney is actually higher than the market capitalization of Caterpillar as of July 28, if the prices of both stocks were to increase by 2%, Caterpillar would have an impact on the index worth about three times Disney’s impact on the average.
Market capitalization is the value of all of a company’s shares of stock outstanding, and different companies have different numbers of shares of stock outstanding.
And why is it called the Dow Jones Industrial Average? The index was first compiled and reported by two financial reporters, Charles Henry Dow, and Edward Davis Jones. Together they founded a company called Dow Jones & Co. The DJIA was only one of the indexes they created around that time; they also reported on an index comprised of 20 railroad companies, which would later become the Dow Jones Transportation Index.
To sum it up, the Dow Jones Industrial Average has a really interesting history (if you’re into that sort of thing). It gives an indication of the performance of a carefully curated selection of companies in the U.S. economy. However, it includes only 30 of the approximately 2800 companies trading on the New York Stock Exchange and 3300 companies on the NASDAQ. In addition, the DJIA only includes large company stocks. What does this mean to you as an investor? A large swing in the Dow probably doesn’t mean that your portfolio increased or decreased by the same percentage as the Dow. But, a large swing in the Dow is often indicative of significant events on the world stage.
This article is intended to be educational and thought-provoking rather than financial advice. When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.