All About the Numbers: Leveraging the Power of the Dow Jones Industrial Average

The Dow Jones Industrial Average is one of the most mentioned stock market indexes in the entire world. You’ll hear it as interchangeable with the current forecast or outlook for the stock market. But how many people really know what it is?

The Dow has become synonymous with economic growth and a strong stock market. It’s one of the oldest most watched indices in the world that includes major companies like General Electric, Exxon Mobil, Microsoft and most recently Apple.

Dow Jones
photo credit: Jeremy Brooks / Flickr

Origins of the Dow Jones

The Dow, as it’s commonly referred to as represents a specific set of major industrial leaders. Its place of origin comes from a man named Charles Dow who created the Dow Jones & Co. firm, the same organization that created the Wall Street Journal. Its progenitor was created on February 16th, 1885 where Charles published a daily journal of twelve stocks he personally selected. The stocks consisted of two industrial companies and ten railroads. Eventually he expanded to twenty stocks.

About four years later, Charles understood the greater importance placed on industrial companies compared to railroads. He created a group of indexes called the Dow Jones Rail Average that turned into the Dow Jones Transportation Average. Finally he created the Down Jones Industrial Average or DIJA. His process for calculation was as follows: adding up the stock price of each company he choose and then dividing the number of companies and getting the results.

This simplistic approach has certainly changed over the year to meet new industries, formulas, and advanced exchange methods. The first Dow Jones figure was 40.94, which meant the average stock price was $40.94 that Mr. Dow has chosen.

Dow Jones Expansion

By 1928 the Dow expanded to include 30 stocks, a current rule that still stands today. The Wall Street Journal’s editors are the deciding factor in what’s included in the Dow Jones Industrial Average. There are no set rules, just a set of guidelines that allows for successful large enterprises to be represented in the major economic activities in the United States.

Every major news outlet or financial application follows the Dow. You can access an in depth explanation and current real-time rendering online from Money Morning and other similar publications.

The change in the Dow Jones can be attributed to multiple factors. Some of these include volatilities in certain market places, all the way to a presidential debate or what some key executives may say or release in a financial statement.

Index Calculation

The usual way of calculating would presume that a stock worth $100, would affect the calculation of the Dow, more so than a $25 dollar share price, even if the latter stock price had a larger market capitalization than the stock worth $100. This underlying calculation method has of course changed over the year to reflect the difference in market capitalizations.

Flaws quickly came to be noticed when companies would announce a stock split or transactions that would affect the stock price in some way. That would include mergers and acquisitions or share buyouts. If a stock were to split 2-1 from $60 to $30, there would be twice as many outstanding shares.

Under the old calculation this largely non-monetary issue change would result in the Dow Jones dropping drastically. As any layperson knows that is not a good sign and would bring turmoil into the market for no apparent reason.

Dow Jones Industrial Average - as of October 10, 2016
photo credit: Google

New Methods of Calculation

The Dow is now a price-weighted index. Stocks that have higher share prices are given more important weight in the calculations of the index. The usual method of just adding up and dividing, may be simple mathematics, but not suitable for a complex system like the stock market.

Overtime the Dow has subtracted and added multiple stocks due to their prevalence in the overall economic sphere in the United States. Now when mergers or stock splits occur, these are accounted for in the overall index. The internal calculations of the Dow get adjusted so that the Dow stays intact.

As the economy is ever changing with new technology markets emerging and old ones fading, the Dow realizes this in its representations. The Dow is not a static index of stocks but a way to change with financial distress or with the different representation of the economy. If there is a major change that is occurring or going to happen, the Dow will make sure to reflect the change.