How the Dow Works

A few numbers make the world go round. The unlimited value of pi. Planck’s constant. e. 867-5309.

And, of course, the Dow Jones Industrial Average.

One of the most common shorthands for the health of the US economy, many people believe that the Dow measures the total value of the U.S. stock market. This is not quite true. It is one of three primary stock indexes, along with the NASDAQ and the Standard & Poor’s 500, and it generalizes the value of U.S. stocks without actually measure the whole market.

Want to know more about how the whole market works? We asked an expert!

Here’s how it works.

History of the Dow

The Dow Jones is a weighted average of 30 different benchmark stocks selected from among the largest and most valuable businesses on the New York Stock Exchange. It was founded in 1882 by Charles Dow and Edward Jones, although at first they just measured transportation companies. It was not until 1896 that the two incorporated industrial corporations into their stock market analysis to create the industrial average as it is known today.

The Dow Jones company has used 30 stocks as its benchmark since 1928, but periodically changes the stocks it includes in the measurement. The stocks are selected from those which Dow Jones believes are major economic leaders based on factors including size, wealth, importance, growth and sector, and they are all picked for their status as “major factors in their industries.”

Why Just Thirty?

Why use just a handful of stocks instead of measuring the entire market? There are three principal reasons:

First, raw size. It would be difficult to track and calculate that much data. The stock market involves so many different assets that pulling them all together would prove very difficult.

Second, speed. The Dow Jones Average moves throughout the day. Up-to-the-minute updates are possible when you are measuring and comparing 30 stocks against each other, but not so much when you are trying to match thousands of moving data points.

Finally, and perhaps most importantly, accuracy. The trouble with using the entire stock market would be isolating the weak data from the strong. Dozens of tiny firms on a downslide can mean real trouble ahead, or it can mean that small businesses founder all the time. If Bank of America drops, however, that sends a much more profound statement about the health of the stock market.

Speaking of data, quarterly reports can become a very big deal…

The Dow and America’s Economic Health

The Dow Jones Average takes its representative stocks and passes their value through the Dow Divisor, which is the weighting process used to control for affects like stock splits and dividend payouts. This makes it what is called a price-weighted index, a more accurate measure than calculating the raw mean.

Only one company has been a part of the Dow Jones Average since the beginning. Although it was dropped for a little while, General Electric was permanently included in 1907. Other companies currently in the average include Apple, Coca-Cola, Disney, McDonald’s, Nike, Pfizer, Procter & Gamble, and Wal-Mart.

Along with the unemployment rate and GDP, the Dow is arguably the most common indicator of economic health in America, but this sampling approach does have a weakness.

What the Dow Jones Average actually reports is the health and trend line for the largest firms on the Stock Exchange. As long as small companies share the same general climate, as they usually do, this makes for an effective synecdoche of real life. However if the value of major firms (like Coca-Cola) departs from the rest of the market, a skewed picture can result.

The result can be the sometimes confusing analysis such as many readers will see currently, with analysts indicating that the strength of the Dow belies the underlying economy.

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