If you read market recaps or scan business headlines, you’re probably used to seeing that “the Dow” finished the day up or down a certain number of points. That’s the Dow Jones Industrial Average—one of the most-watched market indexes because investors consider its performance to be representative of the broader U.S. stock market.
It’s gotten even more attention recently, since analysts have been watching the Dow closely to see if the market’s long winning streak (save a few blips here and there) will continue, and if the Dow will break 20,000 in the next year, as some analysts predicted in early August.
Given how influential the Dow is, you might be surprised to learn it only contains stocks from 30 large companies, including American Express, Chevron, Intel and Disney. By contrast, other widely followed indexes, like the S&P 500 and the Nasdaq Composite, track 500 and about 3,000 companies, respectively. Then again, the Dow is unique in a number of ways.
For starters, it’s an anachronism. It was created in 1896 by Wall Street Journal editor Charles Dow. That was long before the dawn of the computer age, and market data was limited, compared with what’s available today. So Dow chose a simple calculation method: He added up the share prices of each company in his new index, and divided that by the number of companies (hence why it’s called an average). The methodology has since been adjusted in the intervening years to account for the effect of stock splits, but the basic design remains.
The Dow is a “price-weighted” index, which means stocks with higher share prices exert more influence on the index’s movements than stocks with lower share prices. (The S&P 500, on the other hand, is weighted by market capitalization, meaning larger companies have more influence than smaller companies). For example, suppose shares of 3M—one of the highest-priced stocks in the index—were to gain 5 percent by moving to $187 from the Monday, September 12, closing price of $178.10. Due to the Dow’s price-weighting methodology, that move would boost the index by 60 points. However, if shares of Cisco Systems—one of the lowest-priced stocks in the index—gained 5 percent by moving to $33.01 from the September 12 closing price of $31.44, the index would only budge by 10.75 points. A $1 movement by any of the Dow’s 30 stocks moves the index by about 6.85 points.
Another interesting quirk of the Dow? Humans pick and choose which stocks are included, and they don’t rely on strict quantitative requirements or rules to make that determination. The index was long maintained by editors of The Wall Street Journal. But since 2012, it’s been run by S&P Dow Jones Indices, and a group of five people—three from S&P and two from the Journal—meet at least twice a year to talk about whether any stocks need to be added to or deleted from the index.
“Changes are relatively rare,” says David Blitzer, managing director and chairman of the index committee at S&P Dow Jones Indices, who is one of the five who determines which companies are in the index. “It’s not unusual to go one or two years without a change in the Dow.” (Since 2000, there have been 13 changes to the index’s components.)
Blitzer says that some of the group’s considerations include that Dow companies should be “large, leading companies.” Companies must also be incorporated in the U.S., and should already be members of the S&P 500. And the index doesn’t include any transportation or utility stocks, because other Dow Jones indexes track those sectors. But beyond those basic requirements, members of the group have leeway to use their judgment in building an index that represents the U.S. economy.
One final oddity of the Dow: A longstanding pearl of Wall-Street folk wisdom holds that stocks underperform after they’re added to the Dow. “It is possible firms are peaking, or achieving a new high in market interest before inclusion, and therefore struggle to maintain that growth” once they’re added to the index, explains Robert Schmansky, a Certified Financial Planner and founder of Clear Financial Advisors, LLC, in Livonia, Mich.
For example, the most-recent newcomer to the Dow was Apple Inc., which was added to the index on March 9, 2015, replacing AT&T. In the year leading up to its addition to the index, Apple stock returned 68 percent. Since joining, however, the shares have lost around 7 percent, as of September 15.
But for all its quirks, the Dow works as a general market indicator, say analysts. Says Blitzer, “if you look over several years and you plot the Dow and the S&P, you’ll find they move very closely.”