Explaining the Dow Jones

November 16, 2018

The Dow Jones Industrial Average, more commonly the "Dow," has found itself in the financial news frequently over the past two months. In fact, it's been a staple of financial media for over a century. It is the original index, but it's not particularly impressive in its construction. To its credit, "Dow" is easy to say and when you want to feel more sophisticated you can rattle off "Dow Jones." Those resonant linguistics, combined with the index's first mover advantage, have given it staying power.

Charles Dow created his eponymous average in 1896, and it included 12 stocks of large public companies, later expanded to 30 in 1928. That was a time when the idea of a computer was just a twinkle in Alan Turing's boyhood eye, and the average had to be calculated manually. Given the constraints of the era, the average was based on the price of the stocks in the index, and not on the market capitalization (or overall value) of the underlying businesses.

This is important, largely because it makes no sense. Today, a percentage move in Boeing's stock, at $370 a share or so, will move the index much more than the same percentage in Pfizer's. But Pfizer has a larger market capitalization than Boeing, and hence that percentage move economically means more in Pfizer's case.

How does this not turn into a complete dumpster fire? With 30 stocks, the statistics of it are such that much of the nonsense washes away.

Varying methods are used to construct indexes. They can be assembled using market capitalizations, using dividend payout ratios, using other factors in the underlying businesses, or simply using equivalent weights of each company in the index. The differences in index performance over time are non-trivial, as are the risk characteristics. With over 3,000 index funds now tracking these assorted indexes, part of our job is to decipher the optimal tools to use.

One final point on the Dow and media. You've probably noticed the media announcing near-record price movements. Over time, due to inflation, these records will continue to be set. But keep in mind that a 300 point movement at Dow 26,000 is a lot less meaningful than 100 points at Dow 5,000.

It's the percentage movements that matter. But that is not going to sell newspapers, and it is not going to get users onto a financial website, where they'll eventually click on one of those weird "You won't believe Number 18" ads at the bottom, keeping the media company afloat.

Dan Cunningham

Source: The current 30 stocks in the Dow Jones