Market Indexes: The Dow Jones Industrial Average

Market indexes show the general direction of fluctuations in the securities markets and reflect the historical continuity of security price movements. While this information will not necessarily reveal whether individual securities are up or down, it's nevertheless useful to understand how indexes operate because they're commonly used as benchmarks for judging the performance of stocks, bonds and mutual funds. In actuality, market averages are no longer truly averages. The term index is more appropriate, because the numbers given—usually called points—are not dollar-per-share prices of stocks. Points refer to units of movement in the average, which is a composite of weighted dollar values.

Indexes track stocks in particular industry sectors, markets or capitalization ranges. For instance, one index tracks gold stocks; a different index tracks stocks of companies engaged in the distribution and transmission of natural gas. An index exists for each of several exchanges where stocks are traded, including the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX) and the Over-the-Counter Bulletin Board (OTCBB). One index tracks small capitalization stocks, one tracks large capitalization stocks and another tracks all stocks traded in the United States.

An index is referred to as price-weighted when it's weighted by the market price of each security included in the average. Thus, securities with high market prices will be more heavily weighted and have more influence on changes in a price-weighted average. The Dow Jones averages are examples of price-weighted indexes. Conversely, an index is said to be market value-weighted when it's adjusted according to the market value of each security included in the average. The greater a firm's number of shares outstanding and the higher the price of the shares, the greater the weight of that security in a market value-weighted average. The S&P 500 index is a market value-weighted index.

The best-known and most widely quoted index is the Dow Jones Industrial Average (DJIA), published by Dow Jones & Company, often referred to simply as "the Dow." It's also the most widely used stock market indicator, although the S&P 500 has also become an important standard for many.

The DJIA is a price-weighted average of 30 actively traded blue chip stocks consisting primarily of industrial companies. The components represent between 15 and 20 percent of the market value of NYSE stocks. It's calculated by adding the closing prices of the component stocks and using a divisor that's adjusted for stock splits and dividends, as well as for substitutions and mergers. The average is quoted in points, not dollar values. As of this writing, the Dow Jones Industrials includes the following companies:

3M Co. E.I. du Pont de Nemours JP Morgan Chase & Co.
ALCOA Inc. Exxon Mobil Corp. McDonald's Corp.
Altria Group Inc. General Electric Co. Merck & Co. Inc.
American Express Co. General Motors Corp. Microsoft Corp.
American International
Hewlett-Packard Co. Pfizer Inc.
AT&T Inc. Home Depot Inc. Procter & Gamble Co.
Boeing Co. Honeywell International United Technologies Corp.
Caterpillar Inc. Intel Corp. Verizon Communications
Citigroup Inc. IBM Corp. Wal-Mart Stores Inc.
Coca-Cola Co. Johnson & Johnson Walt Disney Co.

The Dow is a statistical compilation that reflects combined, not individual, performances. The two great advantages of the DJIA are simplicity and continuity. The present high level of the average is a result of its continuity. Its base has actually never changed; if it did so, this would, in effect, start a new average.

One criticism of the DJIA is that it exaggerates market movements because it is described in points and runs more than 100 times the straight average price of industrial stocks. Over the years, stocks have been split, but the Dow has not. It has been suggested that Dow Jones split the industrials, or move the decimal point one place to the left. The prevailing opinion, however, is that the average moves up or down strictly according to arithmetic. If the math were changed, continuity—which is the one of the average's greatest advantages—would be lost.

It must be remembered that the market "averages" are no longer really averages, although they were originally and still are referred to as such. Although they are certainly useful measures of the overall movement of the stock market, the numbers themselves must not be confused with the dollar-per-share prices of stocks. This applies not only to the DJIA but to all other stock indexes as well.

The reason for the disparity can be found in stock splits, which occur when a company believes that the per-share price of its stock is too high for broad investor appeal. The company then arbitrarily splits the high-priced shares, creating more lower-priced stocks. For example, if a stock selling for $100 is split two-for-one, the new share price would be $50. Of course, each owner of the old $100 stock must be given an additional share of stock for every original share so that the value of his or her holding will not be reduced.

Stock splitting, which occurs yearly, would distort the averages unless statistical market value-weighted adjustments were not made to compensate for them. Thus, the Dow Jones averages are not dollar averages of current market prices but movement indicators, kept essentially undistorted for more than a century.

Originally consisting of 12 stocks in 1896, the DJIA was increased to 20 in 1916 and then to its present level of 30 in 1928. Whenever any particular component stock for any reason becomes unrepresentative of its industrial sector, a substitution is made and the average adjusted, just as when a split occurs.

Critics sometimes charge that the DJIA includes only 30 companies and therefore fails to reflect the movement of hundreds of other stock prices. But these 30 securities are chosen as representative of the broad market and of American industry. The companies are major factors in their industries, and their stocks are widely held by both individuals and institutions. Changes in the components are made infrequently, often as a result of mergers, but occasionally to effect a better representation.

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