Financial Terms / C - D / Dow Jones Industrial Average (DJIA)

What is the dow jones industrial average (DJIA)?

The Dow Jones Industrial Average (DJIA) has a rich history dating back to the late 19th century. You can trace its roots to 1882 when Charles H. Dow and Edward Jones formed Dow Jones & Company. In 1884, Dow created his first stock average, which included nine railroads and two industrial companies.

On May 26, 1896, Dow introduced the DJIA as we know it today. The initial index consisted of 12 industrial stocks, starting at 40.94 points. These companies represented major sectors of the U.S. economy following a recession in the late 1800s. The original lineup included American Cotton Oil, American Sugar, American Tobacco, and General Electric, among others.

Over time, the DJIA evolved to reflect changes in the American economy. In 1916, the number of stocks increased to 20, and by 1928, it reached 30 – a number that remains constant today. The index has undergone 58 component changes since its inception, with companies being added or removed to maintain its relevance.

Notable milestones in the DJIA's history include crossing the 1,000 mark on November 14, 1972, and reaching 10,000 on March 29, 1999. Today, S&P Dow Jones Indices manages the index, which continues to serve as a key indicator of the U.S. stock market and economy.

Components and Selection Criteria

The Dow Jones Industrial Average (DJIA) consists of 30 blue-chip companies that represent major sectors of the U.S. economy. These companies are carefully selected to reflect the overall market performance and economic health.

To be considered for inclusion in the DJIA, a company must meet specific criteria:

1. Excellent reputation

2. Sustained growth

3. Interest from a large number of investors

4. U.S. incorporation and headquarters

5. Majority of revenue from U.S. operations

The S&P Dow Jones Indices committee evaluates stock prices when considering companies for inclusion. They aim to maintain a balance, ensuring the highest-priced stock isn't more than 10 times the lowest.

The DJIA is a price-weighted index, meaning higher-priced stocks have a greater influence on the index's movement. This differs from market-cap weighted indexes.

Changes to the index occur as needed, with no fixed schedule for reconstitution. Announcements about changes typically come one to five days before implementation.

Calculation Methodology

The Dow Jones Industrial Average (DJIA) uses a unique calculation method. It's a price-weighted index, which means higher-priced stocks have more influence on its movement. To calculate the DJIA, you add up the prices of all 30 stocks and divide by the Dow divisor.

The Dow divisor is a key element in this process. It's constantly adjusted to account for stock splits, dividends, and changes in the index composition. As of January 2022, the divisor was 0.15172752595384. This number helps maintain the index's continuity despite changes in the market.

Here's how it works:

1. Add up the prices of all 30 DJIA stocks

2. Divide the sum by the current Dow divisor

3. The result is the DJIA value

For example, if a stock in the index goes up by $1, you can find its impact on the DJIA by dividing 1 by the current divisor. This gives you the points added to the index.

The price-weighted method is unique to the DJIA. Other major indexes, like the S&P 500, use market capitalization weighting instead. This difference can lead to some interesting situations where a smaller company might have a bigger impact on the DJIA due to its higher stock price.

Significance and Limitations

The Dow Jones Industrial Average (DJIA) holds a significant place in the financial world. As one of the most closely watched stock market indexes globally, it serves as a key indicator of market conditions and the U.S. economy. When the Dow rises, it often signals a positive outlook for the economy, reflecting increased investor confidence.

Despite its prominence, the DJIA has limitations. With only 30 large-cap companies, critics argue it doesn't fully represent the U.S. economy. They suggest the S&P 500, with its 500 companies, offers a more comprehensive view. The Dow's price-weighted calculation method also draws criticism. This approach gives higher-priced stocks more influence, regardless of the company's overall size or market value.

The DJIA's volatility is another consideration. While the index includes well-established companies with low business risk, their stock prices can fluctuate significantly in the short term. This volatility can lead to substantial gains or losses in investment products that track the Dow.