Wednesday, October 04, 2006

Dow Hits Record High. Uh, What is the Dow?

You may have heard in yesterday's news that the Dow closed at a record high, but what is the Dow really?

When people refer to the Dow, they are talking about the Dow Jones Industrial Average (DJIA). It is an index of just 30 U.S. stocks, picked by the editors of the Wall Street Journal. Despite the word Industrial in the name, it actually can include any company except for transportation companies and utilities. It's currently made up of:

Altria Group
American Express
American International Group
E.I. DuPont
Exxon Mobil
General Electric
General Motors
Home Depot
Honeywell International
International Business Machines
Johnson & Johnson
JPMorgan CHase
Merck & Co.
Procter & Gamble
United Technologies
Verizon Communications
Wal-Mart Stores
Walt Disney

A unique feature of the Dow is that it is a price-weighted index. Basically, when it was first started in 1896, they took the prices of the original 12 stocks, added them up, and divided by 12 to get the average. Since then, they have changed the divisor so that things like stock splits don't change the average, but it is still price weighted. So a $1 movement in a $20 stock has the same impact as a $1 in a $80 stock, even though the percentage change in the $20 stock is much higher. This is one of the main criticisms of the index. Most popular indexes, such as the S&P 500, are capitalization weighted, which means that the weight of the components in the index are determined by the market cap (you can think of it as the number of shares x the price).

So what's the significance of the Dow hitting a high? Not much, really. Since it's only 30 stocks, it's not necessarily representative of the market as a whole, especially smaller cap and international stocks. Since it's price-weighted, it's not even necessarily representative of the fortunes of the 30 stocks in the index as a whole. Really the main reason that it is mentioned so often in the media is force of habit. It's the oldest U.S. stock index and has been quoted for over a century. So, the next time you hear that it's hit a record high, take note of it for trivia's sake, but don't change your investing plans.


MillionDollarCountDown said...

You may want to check out this stat. 18 of 30 dow companies are lower today than they were last time dow was at its peak in 2000.

Anonymous said...

Most of these companies were affected by the recession. It affected the average index.

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