When you want to know how the U.S. economy is doing, you look at “The Dow.” It’s the poster boy of financial metrics. The Dow’s up-or-down fluctuations are reported by not just investment nerds, but mainstream news outlets as well.
What Is the Dow Jones Industrial Average?
You’ve probably heard of the stock market. It’s a huge marketplace where investors buy and sell shares of publicly-traded companies on stock exchanges like the New York Stock Exchange, NASDAQ or S&P 500.
There are currently over 2,300 companies being bought and sold on the NYSE alone. The companies operate across the spectrum of industries and each face their own challenges and opportunities. While some boom, others face hard times, therefore it’s difficult to glean any information about the state of our economy based on the performance of one company.
With that in mind, at the turn of the 20th century, Wall Street Journal founder and financial luminary Charles Dow dreamed up a measurement that could be used to provide investors with a reasonable indicator for how the stock market was performing as a whole. This indicator was called the Dow Jones Industrial Average (DJIA), and was originally comprised of 12 of the country’s largest companies, mainly railroads and industrial companies, hence the name. The daily performance of these companies’ stock prices were computed together, averaged and then published for investors.
Unlike the latter part of the 19th century, the stocks that comprise the Dow are not all heavy industrial companies. The fact that we still refer to it as the Dow Jones Industrial Average is simply an homage to its roots. However, there are several other, more industry-specific indices that are used as performance indicators for certain sectors of the economy like utilities, transportation and software.
How Is It Calculated and What Does It Mean?
Today, the Dow consists of 30 large American companies representing various industries, from telecommunications to energy production.
The stock prices of these companies are added together and then divided by what is referred to as the “Dow Divisor.” The Dow Divisor attempts to account for things like stock splits that would change the price of a component stock and fundamentally change the value of the index of itself. Think about it: A stock split halves the value of a stock, but you get twice the amount of stock. It’s not that the value of the company fell by 50%.
Once the stock prices are added together and divided by the Dow Divisor, what you’re left with is an average value that serves as a barometer for how the entire stock market is doing as a whole.
If these companies do well, the Dow goes up. If the results are mixed, it stays flat. If these companies are having a rough time, the Dow falls. If the largest companies representing a mix of industries are having good or bad days, it’s not a difficult assumption to make that smaller companies within that industry are probably faring the same.
Typically, when the change in the Dow Jones Industrial Average is reported (like here for instance), you’ll see a number and a percentage. The number indicates the average value of these companies combined, compared to the opening price for the day. The percentage indicates how large that number is in relation to their total value.
As I write this article, the DJIA is down -57.44, or (-0.36%). That means that the value of the companies in the index is down by 57 points, or around 0.36% of their total value.
Criticisms of the Dow Jones Industrial Average
There’s a reason why the Dow is still around over 130 years after it was created. But it’s not without its criticisms.
Just like any average or index, it’s only as good as the sum of its parts. Some economists believe that you cannot paint an accurate picture of how the economy is functioning by using just 30 companies.
The Dow Jones Industrial Average also has a way of over-representing the importance of the companies that comprise it. Say McDonald’s, for example, is embroiled in a lawsuit which has investors scared. The value of the company would drop, which would affect the value of the Dow as a whole. But, if Wendy’s and Burger King are having great days and selling lots of burgers, McDonald’s case would be an anomaly and not reflective of the fast food industry, or the economy as a whole.
The bottom line is that the stock market and economy are both incredibly complex. It’s impossible to quickly determine its health using just one number, but the Dow Jones Industrial Average does just that. Criticisms aside, it’s used by economists and financial institutions around the world and is likely to stay America’s leading economic indicator.
If so, subscribe now for tips on home, money, and life delivered straight to your inbox.